Distressed Businesses: Overcoming Obstacles in the Road to Recovery

The Arizona economy and our local businesses are suffering significant distress in these uncertain times. A business’ going concern premise is compromised as growth and cashflows decline and risk increases. Financial distress is a condition in which a company or individual cannot generate revenue or income resulting in challenges in paying its financial obligations. This is generally due to high fixed costs, illiquid assets, or revenues sensitive to economic downturns.1 According to news reports2, the City of Phoenix estimates 20-25% of small businesses won’t survive the COVID-19 pandemic. According to a report from the Federal Emergency Management Agency (FEMA), 40% of businesses do not reopen following a disaster and 25% fail within one year. The United States Small Business Administration found that over 90% of companies fail within two years of being struck by a disaster. These are some alarming percentages. According to researchers, cities that are “highly reliant” on elastic sources for their revenue and have a high share of at-risk industries that rely on income taxes will see a more immediate impact. This includes cities that largely rely on sales taxes, because many stores are temporarily closing as states enforce lockdowns.3 According to the Brookings Institution report, 27 cities were identified as having the highest share of elastic sources for revenue from the list of 43 expected to feel the most immediate fiscal impact from this pandemic. Included on the list were Scottsdale and Tucson ranked 21st and 24th, respectively, out of the 27.4

The long-term recovery of businesses can be affected by numerous factors, including the industry in which it operates, how long it has been in business and its financial health before a disaster or economic downturn. Although we cannot predict how long the road to recovery will take, we can take steps to overcome some obstacles along the way.

Business Value and Premise of Going Concern

As businesses begin to reopen, particularly through a phased-in approach, additional challenges requiring attention will begin to emerge that could adversely affect the reinstated operations. Under a going concern premise, the business is assumed to continue operating going forward. Ultimately, that is the road we are diligently working toward. In moving in that direction, we need to address some of the specific company risk that typically exist for distressed businesses:

Key supplier dependence — Small companies typically depend on a single supplier for a product or service. Increased financial pressures could occur if key suppliers reduce credit terms and demand payment in full. Business owners should take steps to minimize risks by researching other suppliers and anticipating alternative credit arrangements.

Customer risk — Customer perception is paramount during the partial/complete reopening of businesses, particularly individual consumers. Clearly delineating and communicating steps taken to keep consumers safe is crucial in mitigating concerns. For commercial customers, establishing strategic plans to address quality of product/service and continued reliability will help to reduce risk.

Workforce reduction risk — Cross training employees helps to alleviate the risk of decreased production or inconsistent quality of services provided.

Litigation risk — Litigation risk is typically heightened during distressed situations. Proactive legal consultation is prudent to assist in managing contingent liabilities/litigious claims.

Regulatory risk — Consider any proposed regulatory changes in the industry in which the business operates. Proposed changes could positively or negatively impact business operations.

Forecast bias — Strategic planning involves cashflow forecasting which could tend to be overly optimistic or overly pessimistic in uncertain times. Setting baseline expectations that are reasonable is challenging. Periodically monitoring forecasts will help to minimize forecast variances.

Business Interruption and Lost Profits

There are numerous instances where business operations are interrupted that result in minimal impact. In other instances, for example a building fire or major equipment failure, there may be long-term waiting periods in resuming operations. Companies attempt to mitigate these risks by establishing disaster recovery plans to address high-risk scenarios. It is generally recommended that business insurance policies be reviewed at least on an annual basis to ensure adequacy of coverage.

Fraud Deterrence and Detection

The National Center for Disaster Fraud (NCDF), established in 2005 in the wake of Hurricane Katrina, is the result of a partnership between the U.S. Department of Justice and various law enforcement and regulatory agencies to form a national coordinating agency within the Criminal Division of the Department of Justice to improve and further the detection, prevention, investigation, and prosecution of fraud related to natural and man-made disasters and other emergencies, such as the coronavirus (COVID-19), and to advocate for the victims of such fraud.

Disaster fraud, which we’ll define as a deliberate act to defraud individuals or the government after a catastrophe, can be divided into five primary categories: charitable solicitations, contractor and vendor fraud, price gouging, property insurance fraud, and forgery.5

According to the 2020 Report to the Nations, one of the primary categories of occupational fraud is asset appropriation (86% of cases), which involves an employee stealing or misusing the employing organizations’ resources. Although it tends to cause the lowest median loss at $100,000 per case, it can cause additional layers of problems particularly in a distressed economic environment. Billing schemes are the most common form of asset appropriation. Other high-risk areas include check and payment tampering as well as theft of non-cash assets.

In a recent survey conducted by the Association of Certified Fraud Examiners, 90% of the anti-fraud professionals reported an increase in consumer scams due to COVID-19. Of those surveyed, 75% said they already have encountered an increase in phishing through government impersonation, and 71% report seeing an increase in charity fraud. They also have experienced an increase in fraudulent vaccines, cures or tests for the coronavirus (66%); third-party seller and buyer scams on legitimate online retail websites (64%); business email compromise scams (62%); and cyberbreaches (61%).6

Analysts anticipate massive frauds on the horizon. Business owners/management should be educated about possible red flags and continue to provide oversight to even limited operations of a business.

Turnaround & Restructuring

Most businesses heading toward financial distress require detailed attention to addressing operating deficiencies as well as strategic changes to the structure of the business. Turnaround is typically used to mean the process of solving the operation problems of a business. Restructuring is typically used to mean the process of developing a financial structure that will provide the basis for turnaround.

There is approximately $10.1 trillion in corporate debt currently outstanding of which $934 billion is distressed, compared with $6.6 trillion in 2008, of which $184 billion was distressed.7

Historically, the economy has seen significant declines and varied recovery periods as a result of U.S. market crashes. The S&P 500 is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies. Below is a snapshot using the S&P 500 price index as the benchmark. As of May 8, 2020, the index rose to 2,929.808, an increase of approximately 31% from March 23, 2020.

U.S. Market Crashes, Using S&P 500 Price Index as the Benchmark

Source: Duff & Phelps
1929 Crash 1987 Crash Dotcom Crash 2008 Crash COVID-19 Crash
Start Date of the Decline 9/16/1929 8/25/1987 3/24/2000 10/9/2007 2/19/2020
S&P 500 31.86 336.77 1,527.46 1,565.15 3,386.15
End Date of Decline 6/1/1932 10/19/1987 10/9/2002 3/9/2009 3/23/2020
S&P 500 4.40 224.84 776.76 676.53 2,237.40
Decline -86.2% -33.2% -49.1% -56.8% -33.9%
Recovery Date 9/22/1954 7/26/1989 5/30/2007 3/28/2013 ?
S&P 500 32.00 338.05 1,530.23 1,569.19 ?
Years to Recover 25.02 1.92 7.18 5.47 ?

During challenging economic times, management needs to develop strategies to safeguard assets and maximize cashflows. Options to consider include debt restructuring, sale of non-operating assets, and investment of new capital from outside sources.

Company management should consider a SWOT analysis pre-COVID-19 to assess the business’ strengths, weaknesses, opportunities and threats and then consider the short and long-term potential effects of COVID-19 on that original SWOT analysis. What steps can be taken to mitigate risks? How can you leverage your strengths against the weaknesses currently being faced?Businesses should consider creating a think tank of opportunities that could be initiated even in the short-term.

Bankruptcy Relief

The Small Business Reorganization Act of 2019 (“SBRA”), Pub. L. No. 116-54, effective February 19, 2020, provides that a small business debtor may elect at the time of filing to proceed under a new Subchapter V of Chapter 11 of the Bankruptcy Code. The U.S. Trustee’s Office website provides details regarding the provisions of the new law, including the legal rights and duties of the debtor and other parties, and the new responsibilities of the United States Trustee.9

The CARES Act temporarily raised the eligibility debt ceiling from$2,725,625 to $7.5 million for new cases filed between March 28, 2020 and March 27, 2021.10

By simplifying the plan confirmation process, lowering costs, and raising the debt ceiling, SBRA can provide another option for small businesses seeking reorganization.

Conclusions

Although we cannot predict the future, preparing for the business challenges ahead takes careful planning and perseverance. So many people throughout history have provided their insights as to how to overcome adversity in difficult times. I would like to conclude with the following thought: “We should remember that good fortune often happens when opportunity meets with preparation.” – Thomas A. Edison.

Josephine Giordano, CPA, ABV, CFF, CFE, CBA, ASA, CDBV, CIRA, CICA, is a Director in BeachFleischman’s Financial Forensics and Valuation Services Group. Ms. Giordano has extensive experience as a financial professional, with a diversified background that encompasses internal audit, banking, tax, business valuation, fraud investigation and forensic accounting, bankruptcy and restructuring, court-appointed Receiverships, court-appointed Special Master and Compliance Monitor, and other litigation support services. She can be reached at jgiordano@beachfleischman.com or 602-792-5981.

Footnotes
  1. https://www.investopedia.com/terms/f/financial_distress.asp
  2. https://www.fox10phoenix.com/news/phoenix-city-estimates-paint-grim-post-coronavirus-future-for-citys-econony, April 28, 2020
  3. https://www.businessinsider.com/fiscal-impact-of-us-cities-from-the-coronavirus-2020-4
  4. Ibid.
  5. Natural Catastrophe and Disaster Fraud, Fraud Magazine November/December 2006, Association of Certified Fraud Examiners.
  6. ACFE Insights, April 26, 2020.
  7. St. Louis Fed; Bloomberg; New York Times; American Bankruptcy Institute’s webinar: Litigation Finance: Lessons from the Last Financial Crisis for the COVID-19 Downturn, May 6, 2020.
  8. https://finance.yahoo.com/quote/%5EGSPC/history/
  9. https://www.justice.gov/ust/file/sbra_legal_manual.pdf/download
  10. https://www.natlawreview.com/article/temporary-and-permanent-changes-made-to-new-small-business-reorganization-act-2019
Josephine Giordano
Josephine Giordano

Josephine Giordano is a Director in the Financial Forensics and Valuation Services Group at BeachFleischman PC.

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