When commercial lenders have advance knowledge of hidden risks and liabilities, they can advise customers on ways to minimize their potential exposure and possibly preempt loan defaults. Or they may decide to deny a loan altogether.
Unearthing not-so-obvious risks and liabilities is multilayered: Lenders should perform industry risk analyses, interview management, request additional documentation and pay attention to business community word-of-mouth. The following questions are meant to help you uncover some of the potential risks and liabilities that can compromise debt service.
1. Is there an overreliance on certain customers? Companies that rely on any one customer for more than 10% of their annual sales (or one supplier for more than 10% of their materials) risk sudden interruption of operations if the customer (or supplier) cuts its ties. Well-written, long-term contracts are one strategy to combat concentration risks.
2. Is there an overdependency on key people? Lenders should evaluate the age and health of key people and the cost to replace them. Volatile employee or shareholder relations may increase the risk of losing a key person. Signed noncompete agreements and key-person life insurance policies may minimize the stress caused by a key employee’s sudden departure.
3. Are there tax problems? When compounded with interest and penalty charges, tax liabilities can quickly take a toll on a business. Lenders should stay abreast of any customers being audited for income, sales and payroll tax deficiencies.
4. Are there any ongoing lawsuits? Pending litigation is expensive, and it can distract management’s attention from the company’s day-to-day operations. Bitter shareholder disputes may even result in court-mandated liquidations.
5. Is there a high risk of fraud? A strong internal control system is the best defense against fraud risks. While most companies worry about employees stealing assets, lenders should also watch out for managers using fraud schemes to misrepresent the financial health of the company.
6. Are there foreign transactions? In addition to obvious geopolitical risks, foreign activity is susceptible to repatriation and foreign-tax issues, exchange-rate risks, or the possibility that a foreign government might expropriate (or repossess) the company’s foreign property.
7. Are there environmental risks? Environmental regulations may require a business to clean up its own property, even if a previous owner caused the contamination. Routine environmental assessments can help manufacturers and processors keep environmental clean-up costs to a minimum.