What does the Titanic have in common with companies such as Silicon Valley Bank, FTX, Greensill, and Pink Energy? They were all at one point considered to be pathbreaking, best-in-class entities with a larger-than-life presence that ended up failing spectacularly. These failures came with plenty of Early Warning Signals, most of which were ignored. The Titanic’s captain reportedly made the decision to sail at full speed despite getting multiple iceberg warnings. Likewise, the failed companies raised several red flags that their creditors chose to ignore to their detriment. These Early Warning Signals or red flags were leading indicators of risk. This blog delves into what leading indicators are and the ones that lenders and investors should constantly monitor if they want to detect risk early.
What are leading indicators of business risk?
Financiers look for risk indicators to gauge how creditworthy or investable a business is. Most of these gauges fall into 2 categories – lagging and leading. Lagging indicators of risk measure a company’s past performance. Common examples of these include financial indicators such as revenue, gross margins, or profits. Lagging indicators are easy to source, quantify, and use as comparison benchmarks making them a foundational tool in risk management. Strictly speaking, however, such information looks at what has already happened and is available for review only on a quarterly or annual basis. This produces a time-lagged, backward-focused review process.
Leading indicators of risk, on the other hand, measure metrics that point to a company’s future performance. Common examples of these include customer satisfaction and brand recognition. Such data can be found on-demand but is harder to source and measure. As a result, leading indicators are often ignored despite their forward-looking quality. But as mentioned before, they act as early warning signals of business distress. For example, a company with low customer satisfaction rates will have a hard time retaining customers and attracting new ones, which in turn diminishes its future revenue prospects.
So, the best way to gain a holistic view of a business is to monitor both lagging and leading indicators of risk. Monitoring only one without the other would be akin to driving a car on 2 wheels – a dangerous and unnecessary approach given that we now have the technology to utilize all kinds of data.
5 leading indicators lenders and investors should monitor
The 5 leading indicators that lenders and investors should always monitor for early risk detection are:
Customer reviews and complaints
Negative news media
Public perception and reputation
Unusual business activity
Legal, tax, and compliance issues
To keep things short and sweet, this will be a 2-part blog. In this blog, we will focus on customer reviews and negative news media. Our next blog will cover the rest. So, watch out for that!
Leading indicator #1: Customer reviews and complaints
We live in the age of information. Nowhere is this more evident than in the world of purchasing. Today, the customer is king and the customer likes to talk. What’s more, people listen. Over 96% of consumers check reviews online before deciding to use a product or service. Such user-generated evaluations hold a lot of sway today with one study reporting that a single negative review can cost a business up to 30 customers. This can make or break a company especially if it is a small business.
In addition, consistently poor feedback can be a symptom of larger problems within a business such as poor leadership or operational rigidity. Take the case of Pink Energy. The solar energy company had hundreds of negative customer reviews and over 1000 complaints filed against it with the BBB (Better Business Bureau) several years before its closure. An examination of these would have revealed a history of overpricing, false advertising, and poor service management – problems that the company never addressed leading to a debilitating drop in sales.
Monitoring review sites such as BBB, Google, Yelp, etc can make financiers aware of such problems well before they show up on the balance sheet. In fact, one study found evidence that customer opinions can inform stock returns and are predictors of future revenue and earnings surprises. Customer feedback also adds to an investor’s due diligence process as it reveals an organization’s strengths and weaknesses – important information to have before taking a stake in a company. All of this makes keeping tabs on popular and industry-specific niche review sites an important exercise for commercial lenders and investors.
Leading indicator #2: Negative news media
With the Covid-19 pandemic came the need for businesses to establish an online presence. Consequently, most businesses today have a digital footprint. It includes everything a company puts out about itself or what others say about it online. This unstructured digital data can be a gold mine of alternate information and insights for financiers that they may not get using traditional credit assessment. An infamous example of this is the 2015 Wall Street Journal article detailing fraudulent practices at Theranos, the highly-touted blood-testing startup. The article unearthed facts that experienced due-diligence teams didn’t.
FTX, another startup darling, also had negative news articles come out against it before it collapsed. A Bloomberg article spelled out concerns regarding the company’s web of conflicting interconnections as did some financial veterans several months before it filed for bankruptcy. The only difference here is that the Theranos article set the company’s unraveling into motion while the FTX article was largely ignored. Had FTX investors investigated these red flags and cashed out before the company imploded, their losses would have been more minimal.
So, there is a lot of value in screening online media for adverse information. This includes local and global news as well as blogs and industry-specific websites. And it's not just about monitoring a business. Monitoring people, counterparties, and foreign subsidiaries connected to a business is also an important undertaking. Such analysis can reveal connections to suspicious individuals and high-risk entities that could cause problems for the company in the future. This can prove especially useful in adhering to AML and compliance guidelines, many of which require adverse media screenings.
Part 2 of this series looks at why lenders and investors should monitor a company’s public perception and business undertakings, along with legal, tax, and compliance activities. You can catch that here.