Fundamental Decisions in a Distressed Organization

An organization that is in distress faces a harsh reality: to attempt to turnaround the business or dispose of it. This existential decision is incredibly time-sensitive, as any delay in action erodes the possibility of a successful recovery. In this article, we will explore the distressed organization and the difficult decisions faced by its stakeholders. We will outline considerations to keep in mind when faced with such a situation. As part of this process, we will also examine short-term survival as a concurrent process of the chosen strategy.

The Key Aspects of Distress

The following are typical characteristics of a distressed organization:

• Corporate malaise
• Pervasive and persistent denial
• Lack of critical thinking
• Wide dysfunction
• Strained management information systems (MIS) that output incomplete, distorted, or even falsified data

The extraordinary demands upon custodial management and lack of perspective are a powerful and negative force in the distressed organization. Flawed information systems and time constraints create a harsh, unforgiving, ambiguous, and tense environment. Success in light of this distress is often determined within the first few months or even weeks of committed planning. If this window of opportunity is not used properly, a second chance is unlikely and could very well result in the erosion or even destruction of any remaining corporate value.

Time Is of the Essence

When an organization is in distress and considering its options, the first step should be to review and strengthen the cash management information systems and manage both external and internal threats. Executed concurrently, these tactics will shepherd all resources, collect and correct data, provide a framework for strategic choice and execution, and mitigate threats. Failure to embrace these tasks and execute them successfully will preclude any successful turnaround or disposition.

During this initial phase, the goals are to:

• Control cash disbursement
• Determine cash flows
• Enhance revenue and decrease costs
• Restore the integrity of the MIS function as needed, including accounting

At any given time during this period, a significant cash deficiency could result in catastrophe, which is why immediate control of cash is paramount. The more conservative and austere the approach, the better. Authority for all cash disbursements should reside with one person who must be experienced in cash management within a distressed organization.

Managing limited resources, multiple threats, and numerous demands requires a level of experience quite different from custodial management. In these situations, companies often appoint a Chief Restructuring Officer (CRO) with requisite experience. In addition to managing cash, this person contributes to the creation and implementation of strategy.

The Cash Budget

The cash budget is the primary tool necessary for cash management. It is an accurate record of historical revenues and expenses, a well-reasoned estimate of the future, and much more. Properly completed, a budget yields rich dividends in the decision-making process and, ultimately, in the execution of strategy.

A well-prepared budget will:

• Assist in the determination of available cash resources
• Quickly outline opportunities for cost reduction and revenue enhancement
• Yield insights into accounting and MIS deficiencies
• Provide a breakdown of revenue and expense in detail by product, market, and division
• Provide insights into the long-term viability of the firm
• Enhance capability for market planning
• Yield information that is valuable in the preparation of other reports, such as balance sheets and income statements

The preparation of the budget is an evolutionary process, given time and data constraints. In distressed situations, cash is often immediately problematic, and a simple report must be prepared ad hoc with a short look forward. This will likely be in the form of a daily cash report. In a simple format, this report includes revenue, disbursements, bank position, and float. It looks forward about two weeks and should be nearly 100% accurate. It is the first line of defense against sudden disasters and quickly delineates priorities.

As data is gathered, tested, and refined, monthly and yearly reports can be prepared on a continuum through the period required to execute the strategy. This process must be governed by a need for both speed and accuracy. It is important to note that the budget process yields benefits before it is complete, including identifying early opportunities to improve both the cash position and management information systems. Completion of the budget should not prevent management from exploiting these opportunities. Planning and action are not mutually exclusive. Their concurrence is essential. Positive action should not be encumbered by excessive analysis. The only sin in these situations is hesitation.

Establishing an Independent Test Group

Establishing an independent test group, or center, is crucial to the speed and accuracy of the cash budgeting process. This team is typically staffed by internal employees, with its head reporting directly to the CEO. Their work will employ incremental testing, contingent upon the perceived risk that the data is reliable. In this way, the center will help to correct accounting and MIS deficiencies while the budget process is underway. This may seem counterintuitive, but again, the budget is an evolutionary and recursive process. During this process, some information is used, some is evaluated, and some is rejected and corrected. Simultaneously, MIS and accounting deficiencies are addressed incrementally. In a distressed environment, a linear approach will fail given the time constraints, and so a multi-pronged, concurrent approach must be taken.

The center will also provide an independent review of assumptions used in the formation of pro-forma revenue and expense. Testing here will include proof of revenue and expense tests, as well as some balance sheet items such as hidden collateral, nonperforming assets, and past-due liabilities. Testing will be incremental in both depth and breadth; typically, it will begin with a cursory evaluation and then evolve to a more forensic level as needed. Testing will include:

• Financial statement analysis
• Comparison and analysis of the trial balance and general ledger
• A review of the general ledger
• Books of original entry, such as purchase or sale
• Source documents

A New Balance Sheet

While the budget is being developed and cash is being tightly controlled, it is important to seek additional cash from all sources. Unlocking additional sources of capital requires a current and accurate balance sheet. In a distressed environment, it is unlikely that one is available so it must be created with a critical eye. Valuation should be viewed with the skepticism of a pawnbroker. Data collected should be verified independently.

The following steps will usually result in a balance sheet that provides an accurate view of assets and liabilities:

1. Visual inspection and inventory of all tangible assets, including equipment, vehicles, real estate, and physical inventory
2. An inventory of all intangible assets, including accounts receivable, patents, trademarks, leases, and interests in other entities
3. A professional evaluation of all assets
4. The verification of all encumbrances, liens, or mortgages on company assets via  competent legal counsel
5. Source verification of the current balances for all loans, mortgages, and financial obligations, with particular attention to those that are less obvious, such as third-party liabilities and contingent liabilities

Sources for additional revenue that may be identified as part of this process include:

• The sale of noncore or nonperforming assets
• Amending payment terms to outstanding debt
• Collecting on past-due accounts
• Statutory or nonstatutory restructuring
• Additional debt, including DIP
• Amending terms on accounts payable or accounts receivable

The Requisites for Turnaround Success

During the process outlined above, the immediate goals are to control the disbursement of cash, define historical data, seek additional sources of cash, restore MIS, and understand the balance sheet. During this process, a wealth of information is revealed that will be necessary for a turnaround or sell analysis. The key elements required for a successful turnaround attempt include:

• cash resources
• a viable core product/service
• competent management

The completion of the cash and MIS tasks will provide most of the data necessary to determine if these criteria are met. It is also necessary to evaluate both internal and external threats to the organization in parallel.

Threats

External Threats

The most significant threats to a distressed organization usually originate from the company’s creditors, with secured lenders having primacy. It is important that nothing be taken for granted and the secured lenders themselves confirm their position. This includes any letters of demand, default or forbearance. In addition, all loan documentation from origination should be cross checked with lenders.

An inventory and review of all outstanding or pending litigation likely encompasses claims of unsecured lenders including third-party claims. In addition, it includes such threats as environmental or human resource issues. Each potential case must be documented with current information from source or counsel. A central file should be created to consolidate this information along with key dates and timelines.

It is important to avoid precipitous action from any source. Even a relatively small event can trigger a downward spiral. Regardless of the position of the company, the best way to achieve this is through open, honest, and forthright communication with stakeholders.

Internal Threats

Internal threats can include employee or union relations, compliance issues, supplier and client relations, and operational risks.

Employee or union relations are of significant importance. Usually, employees at the lowest levels are well aware of the condition of the company. The notion that a turnaround manager will arbitrarily cut staff can decrease employee motivation. Cuts in staff are almost always necessary, however improving operational efficiency requires that morale actually increase. This requires skilled leadership, transparency and communication.

Compliance issues vary by geography and business. Most organizations have issues involving health, safety, labor, and the environment. Specialized and experienced counsel should be used to review outstanding regulations. Once determined, these can be applied to current practices.

Both suppliers and clients are key stakeholders. The loss of an important supplier when cash is limited and credit is unlikely has serious consequences. Often, pressure for payment by needy suppliers leads to promises that the company cannot keep. Above all, the promises and commitments that are made should be honored.

It is essential to review the firm’s customer list in light of potential threats. It is axiomatic that the selling price must exceed production costs. However, in many troubled companies margins are problematic. The budget process will reveal who these clients are. The size of a client should not be confused with their importance.

Operational threats include such issues as the condition of property, equipment, and essential payments. Time spent in front-line operations quickly reveals deficiencies here.

Conclusion

Most organizations exist on a continuum. The endpoints of this continuum are prosperity and liquidation. For most of them, their position will vacillate and move significantly towards distress. For some, this will result in disaster. Acting quickly in the face of decline can result in recovery. It is imperative for stakeholders to understand that in this environment time is very limited and information is likely flawed. Seeking the strategic choice involves managing cash, restoring MIS and balance sheets, and addressing threats. This will provide both the time and information necessary to determine the correct decision between liquidation and recovery and to execute the chosen path.

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Restructuring, Insolvency & Troubled Companies Series
2. Bankruptcy Transactions 301 – Advice For The Advanced Practitioner Series
3. Business Borrowing Basics Series

This article was originally published September 9, 2024.]

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