Three indicators can reveal SME insolvency risk up to four years in advance

 

  • In all four countries, the mean financial profile  of all the insolvent companies we analysed was relatively low four accounting years prior to insolvency. German companies attained a mean financial profile of less than BB-, while the French, Italian and Spanish firms scored around B+. By the last accounting year before the insolvency, the scores decreased considerably down to below B+ in Germany, B- in France and around CCC in Italy and Spain. In comparison, the mean fi-nancial profile of all SMEs & MidCaps in the four countries is about BB.
  • Which leading indicators could allow us to detect corporate distress early? The literature often identifies a decline in turnover as an initial symptom, but our analysis shows that turnover develop-ment is not a robust indicator of corporate distress or increased credit risk in Germany. While it looks more effective in France, Spain and Italy, it’s not fully reliable. Instead, we find three indica-tors which can point to corporate distress three to four years before an insolvency. 
  • The first and most important indicator is profitability. Four years prior to an insolvency, the average Return on Capital Employed (ROCE)  is relatively weak: around 7% for German SMEs, 6% for French SMEs and below 4% for Spanish SMEs. In Italy, ROCE is almost close to 0%. In com-parison, the average ROCE of all SMEs & MidCaps in the four countries is between 10% and 14%. As corporate distress unfolds, companies' profitability decreases significantly, falling deep into neg-ative territory one year before an insolvency.
  • The second indicator is capitalization, which tends to decline along with the decline in earn-ings, albeit at a slower pace. Four years before their insolvency, companies have average equity ratios  of 20.6% (Germany), 23.2% (France), 15.6% (Italy) and 23.3% (Spain). In comparison, the average equity ratio of all SMEs & MidCaps is about 30%. Capitalization deteriorates significantly in the last year prior to insolvency, resulting in over-indebtedness in all countries except Germany. As earnings and capitalization deteriorate, the resulting negative impacts on credit risk clearly affect the deleveraging potential  as well.
  • The third indicator for corporate distress is the interest coverage. As early as three accounting years before an insolvency, companies’ average EBIT-based interest coverage is very weak: between 0.5x in Italy, 0.8x in Germany, 1.0x in Spain and 1.1x in France. Compared to this, the average interest coverage of all SMEs & MidCaps is about 3x. In other words, at this early stage, operat-ing profits are already or close to being unable to cover interest expenses. 

Contact

Ana Boata
Allianz Trade