Identifying Early Signs of Financial Distress

Bankruptcy can have a significant impact on a company’s owners, investors, employees, and lenders. Identifying signs of financial distress is an essential step in ensuring the long-term survival of a business in today’s complex economic landscape. Vigilance in detecting red flags — such as declining cash flow, increasing debt, and falling sales — can help prevent severe outcomes, like bankruptcy, and provide an opportunity for management to make necessary adjustments, restructure operations, or seek external help.

Management is responsible for monitoring a company’s financial health and promptly addressing potential risks of bankruptcy. Critical financial metrics to watch include declining revenue and profit margins, negative earnings, and net losses. Additional financial metrics include balance sheet concerns such as liabilities exceeding assets, rising debt levels, and significant changes in inventory, accounts receivable, or accounts payable. Other significant red flags include decreasing or negative cash flow, such as the inability to cover operating expenses and debt obligations and failing to meet loan agreement terms.

Specific financial ratios can provide early warning signals of financial distress, including:

Debt-to-equity ratio: Provides a key measure of a company’s ability to meet its financing obligations and the structure of its financing. A high or increasing ratio suggests over-reliance on debt financing. An ideal debt-to-equity ratio is around 1.0, though this can vary by industry. A ratio higher than 2.0 may indicate financial distress.

Current ratio: Assesses a company’s ability to meet short-term obligations and is calculated by dividing current assets by current liabilities. A higher current ratio indicates that the company has more liquidity. A ratio below 1.0 is a warning sign.

Interest coverage ratio: Calculated by dividing earnings before interest and taxes (EBIT) by total interest expense on the company’s outstanding debts. This ratio should be above 1.0. Ratios below 1.0 indicate that interest expense exceeds earnings, which signals financial weakness.

Operating cash flow to sales ratio: Measures a company’s ability to generate cash from its sales. Ideally, the relationship between operating cash flow and sales is parallel. If cash flow does not increase in line with sales increases, this is cause for concern. A higher ratio is preferable, indicating efficient cash generation relative to sales.

Altman Z-score: A combination of several financial ratios used to produce a single composite score. This score was specifically designed to assess whether a company is at risk of incurring financial distress. Scores above 3.0 indicate that a company is not at risk of distress. Scores below 1.8 indicate that a company is likely headed for distress.

In addition to specific financial metrics and ratios, there are many other factors that can indicate financial instability when considered in combination with other key metrics. Some of these factors include:

• Difficulty paying suppliers or vendors
• High employee turnover
• Frequent or unexpected changes in key leadership positions
• Legal issues, such as significant lawsuits, regulatory fines, or tax compliance problems
• Loss of market share to competitors
• Significant insider selling
• Switching auditors
• Cutting dividends
• Selling major or core assets, especially if sudden or at distressed prices
• Loss of key franchises, licenses, patents, or principal customers or suppliers
• Delayed financial reporting

Auditors also play a crucial role in assessing a company’s ability to continue as a going concern (i.e., not fall into bankruptcy). They evaluate conditions that may indicate substantial doubt about the company’s financial stability and consider management’s plans to address these issues. If, after considering management’s plans, there is substantial doubt about the entity’s ability to continue as a going concern, the auditor should consider the possible effects on the financial statements and the adequacy of the related disclosure in the company’s financial statements, as well as the audit report should include an explanatory paragraph to reflect that conclusion. 

There are various proactive measures that businesses can take to mitigate bankruptcy risks and maintain financial stability, such as:

Financial Monitoring: Conduct regular financial reviews and forecasting
Cash Flow Management: Develop realistic cash flow projections, monitor expenses, and enhance revenue generation
Cost Management: Evaluate and streamline expenses, eliminating unnecessary costs
Debt Management: Negotiate with creditors to restructure debts and ease financial burdens. Consolidating multiple debts into a single loan or credit facility
Diversification: Diversify revenue streams by exploring new markets or broadening product and service offerings to reduce dependence on a single income source
Securing Alternative Financing: Explore options like small business loans, asset-based financing, or working capital loans to meet ongoing operational expenses

By paying attention to early warning signs of financial distress and taking proactive steps to mitigate financial risks, businesses can build financial resilience and prevent severe outcomes, such as bankruptcy.

Reprinted with permission from the Dec. 17, 2025 edition of the “The Legal Intelligencer” © 2025 ALM Global Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-256-2472 or [email protected].