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.
Examples of Early warning system
- Financial ratio analysis - Financial Ratio Analysis is a technique used to analyze and compare the financial statements of a company over a period of time. This method involves the calculation of various financial parameters such as profitability, liquidity, efficiency, and debt to equity ratio. These ratios are then used to identify any potential problems that may arise in the future.
- Industry benchmarking - Industry benchmarking is a technique used to compare a company’s financial performance with that of the industry or sector average. This method provides an overall view of the company’s competitive position in the market, and can help identify any potential problems that may affect the business.
- Internal audit - Internal audits involve continuous monitoring of the company’s financial operations to ensure compliance with internal regulations and policies. Audits can provide early warnings of potential problems, and can also help identify areas where the company needs to improve.
- Alert and monitoring system - An alert and monitoring system can be used to keep track of any changes in the company's financial condition. This system can be set up to automatically alert management when certain thresholds are reached, allowing them to take corrective action quickly.
Advantages of Early warning system
The Early Warning System (EWS) is an efficient tool for assessing the financial condition of a company. It enables the company to recognize potential threats early and implement appropriate corrective measures. The following are the advantages of having an EWS in place:
- The EWS is able to collect, analyze and provide detailed information regarding the financial performance of the company, allowing for rapid decisions and timely actions.
- The EWS also helps to identify potential risk factors in advance, allowing the company to take proactive measures to reduce the impact of such risks.
- The EWS is also able to detect any financial irregularities, helping to prevent fraud or misuse of funds.
- The EWS also provides an effective way to monitor the performance of the company and ensure that all financial objectives are met.
- The EWS also helps to identify emerging trends in the industry and provides valuable insights for strategic planning.
Limitations of Early warning system
Early warning systems are a valuable tool for assessing a company's financial condition, however it is not without its limitations. Some of the main limitations of an early warning system include:
- Difficulty in obtaining reliable data: Early warning systems rely on accurate and up-to-date data in order to effectively monitor a company's financial condition. If the data is not reliable or of low quality, the system will not be able to provide accurate results.
- Lack of versatility: Early warning systems are designed to detect specific financial issues and trends, and may not be able to detect other types of issues, such as operational problems or changes in customer demand.
- Time lag: An early warning system is only as effective as the data it is based on, and data can become outdated quickly. As such, a system may not be able to detect issues in a timely manner, leading to delays in implementing corrective action.
- Cost: Implementing an early warning system can be expensive, and may require additional staff and resources in order to maintain and operate it.
- One of the approaches related to Early Warning System is the Internal Risk Model (IRM). It is a financial risk management tool used to identify and monitor the risks of a company, such as credit risk, liquidity risk, market risk and operational risk. It uses quantitative and qualitative analysis to assess the potential effects of these risks on the company's performance.
- Another approach is the Financial Stress Testing. It is a tool used to evaluate the potential impact of financial events on a company's financial health. It allows companies to identify the potential adverse effects of a wide range of economic, financial, and operational events on the company.
- The third approach is the Credit Risk Model. It is a tool used to measure and manage the risk of a company's credit portfolio. It uses quantitative and qualitative analysis to assess the likelihood of a company defaulting on its loans and other financial commitments.
- Finally, the Macroeconomic Risk Model is a tool used to evaluate the potential impact of external economic and political factors on a company's financial health. It allows companies to identify the potential adverse effects of economic, financial, and political events on the company.
In summary, Early Warning System is one of the components used to assess the company's financial condition. Other approaches related to Early Warning System include Internal Risk Model, Financial Stress Testing, Credit Risk Model and Macroeconomic Risk Model. These tools allow companies to identify and monitor the potential risks and impacts of external economic and political events on the company's financial health.
References
- Edison, H. J. (2003). Do indicators of financial crises work? An evaluation of an early warning system. International Journal of Finance & Economics, 8(1), 11-53.
- Oliver Schwarz, J. (2005). Pitfalls in implementing a strategic early warning system. foresight, 7(4), 22-30.
- Liu, X. F., Kane, G., & Bambroo, M. (2006). An intelligent early warning system for software quality improvement and project management. Journal of Systems and Software, 79(11), 1552-1564.
