Recognizing Corporate Bankruptcy Red Flags: Wave Systems Corp.

Financial warning signals of business bankruptcy: declining debt ratings, financial statements in the red, falling market cap, and more

In the fast growing internet security industry, hackers and cybercriminals weren’t the biggest threats facing Wave Systems Corp.

Despite increasing demand for cybersecurity solutions, lackluster market performance resulted in heavy losses and insufficient working capital to fund operations. The internet security hardware manufacturer filed for bankruptcy on February 1, 2016.

Wave's downward spiral toward business failure shows a pattern of early financial warning signs that's typical of many public companies, and the lessons from this bankruptcy can be applied to many other troubled companies.

Financial Distress Began Years Before Bankruptcy

An analysis of the financial data shows that financial distress began well before 2014, but the red flags accelerated in the year leading up to bankruptcy.

By September, 2014, multiple indicators of financial health -- operating margin, cash flow, working capital, and more -- were deeply in the red. In December of that year, extremely weak liquidity ratios flashed major warning signs as well.

Investors woke up to the depth of the company's financial problems in June and July of 2015. As a result, Wave's stock prices fell 98 percent, earning the firm a notice of noncompliance from NASDAQ, its listing exchange.  In that same month, the MD&A revealed radical restructuring plans due to a serious capital crunch.

By September 2015, 100 percent of Wave's debt was reclassified as short-term debt. Reclassifying all of its outstanding debt as a current liability is often the result of violations of long-term debt covenants and typically a precursor to bankruptcy.

By November, the company was unable to file a timely 10Q due to insufficient accounting resources. Other early warning signs included: a bottom quartile financial performance in comparison to industry peers, inability to generate positive returns, and a FRISK® Score deep in the red zone. 

One Popular Warning Sign Came Too Early…  

The Altman Z-Score signaled trouble in 2013. Were this early sign heeded, payment terms could have been tightened too early, missing important sales opportunities.

To track deepening financial risk, a predictive bankruptcy score like the FRISK® score can provide more timely insight.  When the FRISK® financial risk score finally signals extreme financial distress, it allows you to take mitigating action without being too restrictive, too early to be useful.

Wave’s FRISK® financial risk score deteriorated leading up to bankruptcy, finally sliding from a "3" to a "2" in September 2015, 5 months before filing.

How to Spot Financial Trouble Ahead

Financial distress typically presents a common pattern across industries. Some lessons learned from this corporate bankruptcy:

  • Business conditions change quickly; it's important to dig into new financial statements as they become available, to track important metrics like profitability, cash flow and liquidity, and watch for key financial ratios that continue to trend down quarter after quarter.
  • It's also essential to watch for rating agency downgrades, sharply declining market cap, and company financial results that consistently lag peers. These are all troubling signs that suggest further scrutiny.
  • A predictive financial risk score can provide a reliable warning of deteriorating financial health, which allows you to mitigate increasing credit risks in a timely manner.

To see how the bankruptcy timeline unfolded for this public company, and to see the entire collection of warning signs to watch for, download the Wave Systems Corp. bankruptcy case study.

About CreditRiskMonitor

CreditRiskMonitor is a financial news and analysis service designed to help professionals stay ahead of public company risk quickly, accurately and cost-effectively. More than 35% of the Fortune 1000, plus thousands more worldwide, rely on our commercial credit reporting and predictive risk analytics for assessing the financial stability of more than 56,000 global public companies.

At the core of CreditRiskMonitor’s service is its 96%-accurate FRISK® score, which is formulated to predict public company bankruptcy risk. One of four key components calculated in the FRISK® score is crowdsourced subscriber activity. This unique system tracks subscribers' patterns of research activity, capturing and aggregating the real-time concerns of what are essentially the key gatekeepers of corporate credit. Other features of CreditRiskMonitor’s service include timely news alerts, the Altman Z”-Score, agency ratings, financial ratios and trends. CreditRiskMonitor’s network of trade contributors provides more than $150 billion in trade data on their counterparties every month, giving them visibility into their biggest dollar risks.