In the first part of his guide to crisis prevention, enomyc author Jan-Ulrik Holsten outlined the patterns that many corporate crises follow and the hurdles that need to be cleared for effective prevention. A significant challenge lies in turning data into actionable insights. In the second installment, he delves into this process, using early risk detection systems as an example to demonstrate their pivotal role in overcoming this barrier.
The importance of early risk detection systems was recognized by legislators many years ago. In 1998, the Law on Control and Transparency in the Corporate Sector (KonTraG) was passed. Section 91, paragraph 2 of the German Stock Corporation Act (AktG) subsequently established the requirement for the management board of a public limited company to implement a monitoring system to detect threats to the company's continued existence at an early stage.
In 2021, the requirements were further tightened, and the scope was expanded to include smaller companies and limited liability companies (GmbHs). Section 1, paragraph 1 of the Corporate Stabilization and Restructuring Framework Act (Unternehmensstabilisierungs- und -restrukturierungsgesetz – StaRUG) stipulates that company executives must continuously monitor developments that could threaten the company's continued existence. Additionally, they are obligated to take appropriate countermeasures in the event of risks that jeopardize the company's survival.
Before discussing the success factors in the design of early risk detection systems, let’s take a look at the systematic stages of corporate crises. This framework has proven to be an important benchmark in practice when it comes to reliably assessing risks and available courses of action.
Crisis Stages and Their Importance for Crisis Prevention
Corporate crises typically do not arise suddenly but follow a predictable pattern that manifests in various stages. These crisis stages often begin subtly and, if not recognized and addressed in time, can evolve into an existential threat for the company. The stages typically range from stakeholder crises to insolvency.
- The stakeholder crisis marks the beginning of a corporate crisis. It occurs when the trust of key stakeholders such as customers, suppliers, investors, or employees begins to decline. Symptoms of this phase, such as increased complaints, are often misunderstood as isolated incidents, leading to their underestimation.
- The strategy crisis is often the next step. During this phase, structural weaknesses become visible. The company may not have responded to market changes or may face competitive disadvantages due to a lack of clear strategic direction. A lack of innovation, an insufficient business model, or a decline in market share indicate deeper issues.
- The product and sales crisis is a direct result of a strategy crisis. The company has failed to adapt to changing market conditions in a timely manner. While measures like product innovations or aggressive marketing strategies can help, they are time-consuming and costly.
- When declining sales and profits begin to pressure earnings, the company enters an operational crisis. As financial flexibility diminishes and investments are scaled back, the crisis becomes more apparent internally.
- In the liquidity crisis, the company is already existentially threatened. It occurs when short-term liabilities cannot be met due to insufficient liquidity. Payment defaults, delayed wage payments, and impending insolvency applications make the crisis visible both internally and externally.
- At the end of the downward spiral lies insolvency. In this stage, the company is either insolvent or over-indebted. The path to this point is often paved with missed opportunities. However, many corporate leaders are surprised to find themselves "suddenly" in an operational or even liquidity crisis.
In the early stages of a crisis, the crisis indicators are often subtle and difficult for management to recognize. However, the more obvious the crisis becomes, the harder it is to take effective action. This is why it is crucial to identify risks as early as possible and take corrective measures.
Many contributions on crisis prevention focus on crisis indicators that are obvious to everyone. However, the key to successful crisis prevention lies in the early identification and use of weak, initially subtle signals. In the next chapter, we will present practical success recipes for implementing early risk detection systems based on these "weak early warning signals."
Key Considerations in the Design and Use of Early Risk Detection Systems
Successfully managing a company requires not only the skill to address current challenges but also the ability to recognize and counteract future risks. An early risk detection system based on weak early warning signals is essential for this.
When designing an early risk detection system, it is crucial to take into account the specific needs and challenges of the company's industry and business model. Successful companies distinguish themselves by developing a customized system that addresses not only general but also company- and industry-specific risks. At enomyc, this approach is known as "SAFE," which stands for Strategic Analysis for Early-warning. SAFE integrates key best practices from over a thousand projects and provides a framework for the design and use of early risk detection systems.
The design and use of such a system should follow nine steps, with particular attention given to the following aspects:
- Analyze the business environment: Identify potential developments for the success and sustainability of your company based on macroeconomic conditions (PESTEL), industry trends, and the "5 Forces."
- Examine company processes and interfaces: Challenge your business model and processes (e.g., finance, production, supply chains, IT systems, human resources, legal framework). This forms the basis for early risk identification.
- Conduct a risk inventory: Catalog potential risks across various business areas to create a comprehensive risk profile.
- Prioritize key risks: Assess the identified risks in terms of importance to focus on the critical factors. A common approach to prioritization uses the criteria of the likelihood of occurrence and impact on business operations.
- Develop indicators: Define specific, measurable early warning indicators that point to changes in key risk areas.
- Set alarm thresholds: Define thresholds (or change rates) that trigger reflection processes and, if necessary, the implementation of prepared measures.
- Prepare actions: To respond quickly when alarm thresholds are reached, corresponding action plans should be developed in advance. Successful companies think ahead during the planning stage and have contingency plans in place to act immediately when required.
- Establish monitoring mechanisms: Implement processes for the regular monitoring of these indicators to respond to changes in a timely manner.
Below, we provide examples of characteristics that have proven to be effective early warning signals in established risk detection systems.
Examples of Early Warning Signals in Different Crisis Stages
Stakeholder Crisis: The first signs of eroding trust among key stakeholders emerge. Early warning signals include:
- Increase in customer complaints.
- Rising employee turnover.
- Decline in repurchase rates (decreasing customer loyalty).
Strategic Crisis: The company is no longer optimally aligned with market conditions. Important early warning signals include:
- Decrease in market share.
- Decline in innovation rate.
- Loss of key customers.
Product and Sales Crisis: This stage is marked by falling sales numbers. Key early warning signals include:
- Decrease in sales figures.
- Increase in inventory levels.
- Decline in orders.
For each of these early warning indicators, it is essential to define clear alarm thresholds. If these thresholds are exceeded, the pre-planned measures should be implemented. For example, if there is a significant drop in sales, marketing efforts can be intensified, or pricing strategies revised, without having to wait for prolonged decision-making processes.
Risk Early Warning Systems Make Companies More Resilient in Crisis
A risk early warning system based on weak early warning signals is a valuable tool to alert companies in advance of impending crises. The combination of carefully selected early warning indicators, clearly defined alarm thresholds, and pre-planned actions can be the deciding factor for a company's survival. Successful companies not only implement these systems but also continuously maintain and adapt them. These companies are able to overcome the first of six barriers to successful crisis prevention (as discussed in Part 1) by generating purpose-driven information from data within the framework of a risk early warning system. The second barrier involves the challenge of transforming information into knowledge and using it to make informed decisions. More on this in the next post.
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Quick-Check: How Effective Is Your Risk Early Warning Management?
As an introduction to the topic, our SAFE approach offers a practical quick check. It provides a quick overview of the maturity level, strengths, and development areas of your company's risk early warning system. Book your appointment for a no-obligation presentation of our "Quick-Check Risk Early Warning" here.
About the Author
Jan Ulrik Holsten, Partner at enomyc, is responsible for Sales and Marketing. He leads comprehensive turnaround and value enhancement projects as a consultant and interim manager. The current post highlights a key solution approach from our consulting portfolio, which has proven to be a valuable lever for improving profitability and enhancing competitiveness. Other focus areas of Jan Ulrik Holsten include Corporate Profit Improvement and Working Capital Management. Learn more about Jan Ulrik Holsten here.
