Early warning system

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Early warning system
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The Early Warning System is one of the components used to assess the company's financial condition (financial liquidity, profitability, indebtedness, efficiency of the company's operation). It enables us to recognize the threat early and launch appropriate repair processes. The EWS is also a part of the information system in a given company, which collects, analyzes and provides information supporting the decision-making process. The effectiveness of such a system depends on the quality of information, in other words, its detail

For the early warning system to fulfill its role, it must be characterized by such features as: versatility, comprehensiveness, flexibility, effectiveness and efficiency.

Main goals, tasks and functions of the early warning system

The task of the early warning system is to reveal the deteriorating economic and financial situation of an economic entity by providing economic data, e.g. in the form of indicators enabling further decisions to improve the condition of an enterprise.

For the existence and use of an EWS to have meaning, one must remember about several conditions necessary to meet. One of them is the efficiency of the system. The early warning system must be checked to indicate the most likely hazards. That is why it is important to test it in a long time with possibly unchanging environmental factors.

It is also very important to precisely define the moment of bankruptcy of an economic unit, because in various countries under the influence of various environmental factors, the fact of bankruptcy may be subject to considerable time and differences of meaning. In order for the unit at risk to have time to take corrective actions, disclosure of risks should take place in advance in time, so that the analysis of the operating business unit can be carried out using data from financial statements or deciding to conduct an internal inspection of the enterprise. The first method is used more often, because the data contained in the balance sheets of companies seem to be more reliable than their own internal observations.

The history of the creation of early warning systems

The EWS appeared as a response to the numerous bankruptcies of enterprises during the Great Economic Crisis (1929-1933), when managers were not able to foresee the threat of danger without sufficiently early information on threats.

We distinguish three generations of the early warning system according to J.K. Hunek can be characterized as follows:

  • First generation - the use of information systems in annual and short-term planning, the primary function of which is to alert about deviations occurring in the implementation of the plan, i.e. differences between actual and desired values.
  • The second generation - the use of information systems, the construction of which was based on the use of a catalog of purposefully selected areas of observation and a set of indicators. The latter are connected with potential sources of threats and opportunities from the environment as well as the company itself.
  • The third generation - the use of early recognition information systems based on the concept of weak signals created by H.I Ansoff. He defines them as imprecise signs of impending changes coming from the distant environment of the enterprise. Weak signals are scattered and their perception requires meticulous observation and extensive analysis.

Currently, only for "management amateurs" the vision of company bankruptcy is often perceived as a threat or even as an inevitable attempt to bankrupt. For managers and entrepreneurs, this is a signal to take action to improve the situation. Therefore, skillfully managing risk and measuring them with the use of early warning systems can effectively predict future events that threaten the existence of an enterprise.

Types of early warning systems

The basic criteria for the division of EWS are the subjective criteria (the unit creating the system, the type of enterprise for which it is created) and the subject criteria (mainly regarding the selection of the best analysis tool). When selecting the appropriate type of early warning system, the given criteria should be taken into account by extending them with additional information specific to the examined entity (e.g. industry, legal form).

One-dimensional early-warning systems - each variable is analyzed separately

  • P.J. Fitz Patrick's Early warning system (the system of pairwise comparison of solvent and "bankrupt" companies using the following ratios: net financial result / equity and equity / foreign capital),
  • C. L. Merwin's Early warning system - the most important indicators are: working capital / foreign capital, own funds / capacities, current assets / current liabilities,
  • W. H. Beaver's Early warning system - based on 6 indicators - the most important one is: financial surplus / total liabilities,
  • P. Weibel's Early warning system - based on 6 indicators, he constructed 3 classes of bankruptcy risk.

Multidimensional early warning systems - analysis of at least two components

  • E. I. Altman's early warning system - the most popular in the US, mainly used for analyzes of listed companies, on the stock exchange
  • G. Weinrich's Early warning system - applied a scoring scheme, based on which he identified three classes of risk,
  • K. Beermann's early-warning system - individual weights are assigned to scales depending on the time horizon,
  • E. Bleier's early warning system - based on data obtained from 6-16 indicators, calculated on the basis of the current year and two previous years.