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Recognizing Potential Problem Borrowers

The symptoms listed below are displayed by sound companies as well as potentially weak ones.  However, if you put enough of these symptoms together, you may have a fairly good indication of near-term trouble.

The best cure for probable loan problems is fast action.  Financial figures often tell a story that will enable you to act in time.  In many cases, unfortunately, it takes considerable skill to understand what the figures really do say.  The following comments provide some insight into many of the things a good analyst should look for in his study of any given set of statements.


1)      Deterioration in the customer’s cash position.  This may be a drop in dollar levels or in the percentage of total assets.  It is often accompanied by marked changes in deposit activity, including overdrafts, draws on uncollected funds, more frequent and smaller depositing of checks, and declining average monthly balances.

2)      A slowdown in the receivables collection period.  Follow-up on this symptom often reveals that the borrower has become more liberal in his credit policies, has softened his collection policies, or has become sloppy and neglectful.

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3)      Changes in credit and sales philosophies. Companies that have sold on regular terms suddenly have new classes of receivables.  Installment sales replace stricter terms.  Items that were once sold are offered on lease rather than purchase terms.  Finance or leasing may seem attractive, but most small and moderate firms just don’t belong in those businesses.

4)      Sharp increases in the dollar amounts of accounts receivable or the percentage of total assets.  A simple request for a receivables aging may well show substantial concentrations with a few customers – or worse, with a single customer.  Where such customers are of questionable financial strength, the risk becomes disproportionately high.

5)      Noticeably rising inventory levels, both in dollar amount or as a percentage of total assets.  Jumps here are usually supported by trade suppliers – an extremely risky process.  They may also be related to the borrower’s natural reluctance to liquidate excessive or obsolete goods at a reduced price.  Too many businessmen sacrifice liquidity in an effort to maintain established gross profit margins.

6)      A slowdown in inventory turnover.  Follow-up here may indicate overbuying or some other imbalance in the company’s purchasing policies.  Often it indicates that they are frozen into some slow-moving items.  If you have knowledge of a cushion (under-evaluation) in the inventory, the actual turnover is even slower than your calculated results.

7)      A decline in current assets as a percent of total assets.  Short-term lenders rely upon the conversion of working assets as their normal source of repayment.  As funds become increasingly concentrated in less-liquid assets, the short-term creditors must look to a different class of assets to cushion their risk.

8)      Marked changes in the trading asset mix.  While the swing from inventory into receivables is normally an improvement in liquidity, the analyst must recognize that these receivables include unrealized profits until they are collected.  As the concentration swings back into inventory, the analyst must recognize that the higher inventory level is a cost disguised as an asset until it’s sold.  In other words, it’s an investment.

9)      Falling concentrations in fixed assets.  This can indicate funds needed to purchase fixed assets are being used for other operational purposes.  This creates problems in times of rising costs when replacement, renovation, and remodeling pose possible serious drains on cash or cause a near-term need for large amounts of long-term debt.

10)  Rising concentrations in fixed assets.  This can be serious when achieved at the expense of other asset needs.  Levels well above industry norms are an added indicator of potential trouble here.  Also significant is the related rise in funded debt to support such acquisitions, especially when the company has committed a sizable portion of its future earning to paying for such acquisitions.

11)  Revaluation of assets for statement purposes.  This is most commonly seen in the fixed asset area.  It is justified to the extent it reflects more realistic values.  It cannot be justified as an inducement to the banker to increase his loans.  It creates no new values.  The values, if they existed at all, were there before.

12)  The existence of heavy liens on assets.  The extent to which preferred creditors have claims on various assets is a key to what may be left for general creditors.  Evidence of second and third mortgage holders is a sign of greater-than-average risk.  The cost of junior money is high.  Most borrowers are reluctant to use this source unless more conventional sources have been exhausted. 

13)  Concentrations in non-current assets other than fixed assets.  Two main categories require special consideration.  A common problem is the perpetual pouring of money by a parent company into affiliates or subsidiaries for which the bank can obtain no information or insight into the real values of those companies.  The second is the tendency to drain working assets to build an investment portfolio of so-called marketable securities.  This is especially dangerous when current creditors are increasingly supporting working asset purchases.

14)  A high concentration of assets in intangible values.  The problem with intangible assets from the banker’s viewpoint lies in proper assessment of their value.  Intangible assets shrink or vanish much faster and more extensively in liquidation than do hard assets.  Remember that most prudent credit analysts eliminate the intangibles in computing a company’s net worth.

15)  Disproportionate increases in current debt.  The element of risk is always greater under the following conditions:

       a)      The rise is concentrated in trade debt.

       b)      The rise is in “friendly debt” (monies due officers and stockholders) where there is no intent or willingness                                   to subordinate the funds to other creditors.

       c)      There is no corresponding increase in the levels of assets, current or otherwise.

16)  Substantial increases in long-term debt.  This is serious when repayment must depend upon a flow of funds which would represent the bulk of anticipated earnings over many years.  A less-than-satisfactory historical earnings record makes such commitments even more dangerous.

17)  A high debt to capital relationship.  This is even more serious when the current ratio is low.  Poorly capitalized companies will generally show poor working capital conditions.  Even if there is adequate working capital, it generally is the result of heavy term-debt funding.  Future earnings, normally a source of working capital growth, might well be used exclusively for debt service.

18)  A major gap between gross and net sales.  This represents a rising level of returns and allowances, which could be caused by lower quality or inferior product lines.  Customer dissatisfaction can take the form of cancellations, complaints, and loss of goodwill.  The lower gross sales levels usually occur on a delayed basis.  This gap can also affect receivable quality and quantity, both from customer refusal to pay and from product returns which lower outstandings.

19)  Rising cost percentages.  Keep in mind that a one percent cost increase on $1 million in sales represents a decrease of $10,000 in pretax profit.  When the cost increase comes in cost of goods sold, it may reflect the borrower’s inability to unwillingness to pass higher costs along to his customers.  When it appears in the operating area, it may reflect a loss of control over a particular segment of general, selling, or administrative expenses.

20)  Rising sales and falling profits.  The fall in profits may be in dollars or in profit margins or in both.  Unless the company is heavily capitalized, this circumstance will ultimately be reflected in an increasing reliance upon debt.

21)  Rising levels of bad debt losses.  Unless this remains constant as a percent of sales, it normally signals deterioration in customer quality.  It is usually accompanied by a slowdown in average collection period.  It is generally advisable to check loss reserve levels to determine whether or not increases have been made to recognize the higher loss risks involved.

22)  A rising level of total assets in relation to sales.  No one questions the fact that when you do more business, you will normally require a higher level of inventory, carry greater receivables, and probably need more fixed assets.  The time to raise questions is when assets rise much faster than sales growth warrants.  If they do, it’s usually the creditors who finance the higher asset levels, simply because those assets aren’t paying their way in the form of higher profits.

23)  A rising level of total assets in relation to profits.  The real investment of any business is represented by its assets rather than its capital.  The fact that a portion of these assets is debt-supported is not pertinent because the company remains obligated to pay those debts.  The assets exist solely to add to earnings and when the assets earn increasingly less in relation to their size, we have a more accurate barometer of failing performance than return on capital will show.

24)  Significant changes in the balance sheet structure.  These need not be the customary signs of deterioration mentioned previously; rather they are represented by marked changes spread across many key items.  These alterations are a cause of concern when we see no signs of market or economic change, no drastic changes in sales or profit levels, nor possess any knowledge of a change in product lines or the general nature of the business.  As an example, the disappearance of a large segment of fixed assets accompanied with new alignments of funded debt and unexplained capital adjustments may well be evidence of a switch to sale and leaseback arrangements, unknown to the bank and missing from the statement notes.

This information was obtained from a handout provided in credit training at Southeast Bank NA in the mid-80s.  I am not sure who was the original author, but the topics remain relevant today.

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