It seems as though the resilience of small and medium-sized enterprises in our country is now slowly coming to an end: Exhausting years of the coronavirus pandemic, rising raw material and energy costs due to wars and ongoing geopolitical conflicts, a bureaucracy that devours resources, and a growing shortage of skilled workers caused by unfavourable demographic trends. A company is now filing for insolvency every 19 minutes.1
This is a crisis of historic proportions that is affecting almost everyone involved: first our customers, and consequently us as a credit institution. We recognise the warning signs from previous ‘hard times’: annual accounts are being submitted later and later, requests for credit increases with vague justifications are becoming more frequent, overdrafts are widening and loan loss provisions are rising. We are in the midst of this development and must actively address it. We will get through this phase, and the economic climate will improve again. It is crucial, however, that we learn the right lessons from this and make decisions now that are swift, consistent and sound.
Lending standards: Driving the supervisory dialogue and portfolio management
The three stages of a corporate crisis
The first step must therefore be to identify problems among our borrowers at an early stage so that we can then take effective countermeasures. In practice, we repeatedly observe three chronologically successive stages of crisis leading up to insolvency:
- strategic crisis
- profitability crisis
- liquidity crisis
When it comes to the eleventh hour: the liquidity crisis
Let’s start with the liquidity crisis. This usually marks the final stage of a serious corporate crisis. Recognising this stage requires neither complex analytical methods nor any particular intuition: unauthorised overdrafts, rejected direct debits and garnishments often culminate in a visit to the insolvency court on a Friday afternoon. By the time our automated monitoring systems at account level are triggered, it is often already too late to take preventative measures.
Cash is King.
Borrowers who, until now, have been able to afford the luxury of unused credit lines suddenly find themselves needing to overdraw. To finance taxes, losses, interest and repayment instalments, withdrawals or maintenance investments. Because cash flows are no longer sufficient.
We must therefore be able to identify promptly when our working capital loans have inadvertently been used to finance ‘no-nos’ – items that a company should be generating itself in normal times. Unfortunately, this is anything but straightforward. This is because the consistently vague, unspecific stated purpose in the loan agreement (‘working capital requirements’) and the subsequent monitoring of fund utilisation – which is impossible to manage without the relevant expertise – often turn a working capital line into a black box.
Specific key figures (e.g. adjusted net working capital (BNUV®)) or the analysis of a cash flow statement provide valuable insights into the actual use of funds in the past financial year: Were receivables and inventories actually financed in the short term via the overdraft facility, or were the credit facilities misused?
When profits dwindle: The profitability crisis
A profitability crisis manifests itself in falling annual results, which, in the worst-case scenario, have a direct impact on cash flow. The causes are varied: limited margin potential for the company’s own products or services due to economic conditions, rising costs of materials and external services, increasing expenses, or inadequate working capital management.
One might be tempted to argue:
Whilst it is regrettable for the business owner if profits fall, as long as the bank receives its interest and capital repayments on time, there is no need for action.
This is a dangerous misjudgement. A financial structure that is sound for lenders necessarily requires motivated equity investors. If the entrepreneur loses motivation for their business activities due to a lack of success, creditors will also suffer sooner or later.
Whilst falling operating profits and shrinking gross profit margins already indicate an advanced stage of decline, there are (new) early warning indicators that signal an impending earnings crisis:
Adjusted Net Working Capital (BNUV®)
Every business requires working capital, which ultimately needs to be financed. This can be done interest-free (e.g. through customer prepayments or supplier credit) or at interest (e.g. through bank loans). The adjusted net working capital (BNUV®) ratio indicates which portion of working capital must be financed externally – and is therefore usually interest-bearing – whilst also serving as an excellent indicator of the maximum working capital financing required.
An absolute increase in the BNUV® from one year to the next is by no means negative in itself. A growing company naturally requires more current assets and thus a higher level of external financing. However, the key factor is the reason behind an increase in BNUV®: is the rise in external financing due purely to growth, or are we, as lenders, financing a deterioration in operational efficiency (e.g. poorer inventory turnover, longer receivables collection periods)? This is highlighted by the BNUV® efficiency ratio, which compares the company’s BNUV® requirement to its turnover. If a company records a deterioration in BNUV® efficiency for two consecutive years, an in-depth analysis of working capital management is urgently required.
The BNUV® can also be used to determine the long-term minimum requirement for external working capital financing. According to the Golden Rule of Financing, medium- or even long-term requirements (fixed assets, but also dead stock within current assets) should not be financed permanently via short-term credit facilities. If a borrower is unable, over time, to at least partially meet their working capital requirements through contraction, the bank’s credit facilities are not financing a temporary liquidity requirement, but rather a permanent requirement in current assets. This results in a deterioration of balance sheet and financing structures and an increase in the probability of default.
Debt capacity and risk-bearing capacity
Our risk traffic light remains ‘green’ only as long as borrowers generate sufficient cash flow to service their debt. But how much debt can a company sustainably afford?
When making lending decisions, every financial institution uses the debt service calculation (DSC). To do this, the cash flow available for debt servicing is calculated (e.g. EBIDA – earnings before interest and depreciation, but after tax, appropriate management remuneration and necessary maintenance investments). This cash flow is then compared with the current debt servicing costs. If this cash flow exceeds the sum of interest and principal repayments, the customer is deemed capable of servicing the debt.
However, this short-term analysis does not answer the question of how long the theoretical debt repayment period is and, consequently, how high the structural risk is for us as lenders. This is because the unavoidable business risk for a lender lies in the possibility that unforeseen adverse events may occur during the term of the loan which could not have been anticipated from the original analysis (management, market, sector, competition, financial data). In this respect, the time horizon of the traditional debt service coverage ratio (DSCR) is too short-term. A significantly better answer is provided by debt-bearing capacity, which allows for a present-value assessment of a borrower’s ability to service its debt over a longer period.
A conservatively calculated debt-bearing capacity, based on sustainable cash flows, indicates how much interest-bearing debt a company can afford within a reasonable timeframe without having to increase its turnover or improve its profitability.
If debt and debt-bearing capacity (DBC) increasingly diverge, this growing DBC gap indicates an increased creditor risk. The repayment period extends beyond an acceptable level. Consequently, the bank assumes increasingly higher risks, which, beyond a certain point, should actually be borne by the equity provider.
The beginning of the end: the strategic crisis
The strategic crisis lies at the root of all undesirable developments. It is the most difficult to pinpoint and requires the most in-depth analysis, as well as a thorough understanding of the customer market.
A sustainably successful company must generate sufficient value creation (cash flow, profit, return on equity) to meet the demands of debt and equity investors in the long term. There are essentially two strategic models to choose from:
- margin leadership (differentiation through quality, innovation, brand, service or niche positioning)
- cost leadership (optimisation through lean processes, low fixed costs and high capacity utilisation)
Strategic positioning: the automotive industry as an example
The margin leadership model (Ferrari as an example):
Vehicles are positioned on the market with high margins and prices. This requires continuous investment in research and development, high-quality materials, brand management and first-class service. This results in a high level of capital tied up and a correspondingly high equity requirement. In normal financial years, this is rewarded with double-digit returns on turnover (2025: 22 per cent)2, which are also urgently needed to make the necessary high fixed-cost base affordable in the first place.
The cost leadership model (Dacia as an example):
Here, a strict focus on costs is paramount. By utilising tried-and-tested group components, highly automated manufacturing in low-wage countries and consistent standardisation of the product range, an attractive selling price is achieved. Although this segment does not achieve top-tier returns on sales (usually 5 to 10 per cent)³, the overall return on capital employed is nevertheless attractive. This is due to the highly efficient use of resources, lower capital tied up through tight working capital management, a high degree of automation and low fixed costs.
Implications for credit analysis
If the company’s strategic direction is not clearly defined prior to a credit decision, it is not possible to assess the quality of its earnings performance. A reported return on sales of, for example, 8 per cent may represent an excellent result for a cost leader, but for an established margin leader, it may already signal the early stages of a serious strategic crisis.
Conclusion
Traditional corporate analysis, which focuses solely on the past, and a ‘wait-and-see’ approach until account-based warning systems flag a crisis are, in this day and age, akin to trying to drive a car safely through traffic whilst looking only in the rear-view mirror.
The identification and quantification of credit risks become significantly faster and more reliable if hidden or creeping changes in customer engagement are detected at an early stage and interpreted correctly. However, this requires the adoption and consistent application of new analytical techniques, which the supervisory authority also included in our terms of reference some time ago (‘EBA indicators’).
Only this optimised look ‘under the bonnet’ enables a holistic, forward-looking assessment of companies’ economic performance in these challenging times. After all, the book profits and equity ratios of the past do not guarantee tomorrow’s debt servicing.
