When it comes to assessing business distress and a company’s insolvency risk, there are two approaches: the technical approach and the commercial approach. The first focuses on the net asset position and the latter on a company’s ability to pay its debts as and when they fall due.
Below, we focus on the indicators to look for beyond an underwater balance sheet to assess business distress and whether a company is at risk of trading while insolvent. We’ll also explore how to discuss these issues with your trusted advisors.
Trading losses are not always an indicator of insolvency, however if not addressed, will erode a business’s liquidity and potentially pose a threat to a company’s solvency.
Where trading losses are apparent, you need to identify who is funding the losses.
Is a company director or related party funding the losses? If so, is this sustainable and is the funding being made in a conscientious manner or in an ad hoc way that offers little protection for the funding party?
Is the business not paying certain creditors such as the Australian Taxation Office (ATO)? This is not a long-term strategy and if creditor management is required in the short term, it is important to assess a creditor’s will and skill to affect the business. For example, the ATO could issue a Director Penalty Notice, a secured creditor could repossess assets, trade creditors could stop supply, etc.
Is third party finance being used or needed? A strategic plan for funding and knowing how much runway it provides is critical.
Poor cash flow
A profitable business on paper may still be burning cash. If it is, you need to determine whether you’re facing a temporary lack of liquidity or an endemic shortage of working capital.
When discussing cash flows, the focus should be on:
- Whether poor debtor collections are a result of lack of focus / effort in collection process, customer credit issues or low product or service quality?
- How quickly is inventory turned over and whether any redundant stock exists and can be liquidated?
- What is the tipping point for enforcement action by a creditor not being on time and what actions are available to creditors?
- Is there any capex that can be deferred or non-core assets that can be sold?
- Do the current financing facilities align with current funding needs or were facilities structured at a time when the company was in a more stable position?
Pinning hopes on the next ‘big contract’
Hope is not a strategy and chasing revenue just to ‘feed the beast’ could impact margins and profitability and exacerbate financial distress. So, at times of risk the questions that should be asked are:
Is there a clear logical business case for new work?
Is there data available to assess the contribution margin of any new work?
Can the overhead structure be adjusted in the short term to accommodate lower gross margins?
Is the business avoiding ‘strategic’ contracts that offer longer term benefits at the expense of the short term?
Is there sufficient margin of error or flexibility in contracts to accommodate supply chain price increases?
Do you have the capacity to deliver on contract? Nothing erodes liquidity quicker than having retentions withheld and getting bogged down in contractual disputes.
Inability to produce timely and accurate financial information
Bad data leads to bad decisions. If a business is unable to produce timely data on its financial position, rarely is the prognosis going to be better than expected.
Most companies experiencing financial distress won’t be able to completely revamp their financial reporting systems. This means that in the short-term, cash flow reporting should be the focus rather than profit and loss. Directors should take control of this reporting and not delegate the responsibility. This will allow them to closely guard cash outflows and pull the right levers to increase cash inflow. Measuring actual performance to forecasts will create accountability within the business.
Negative business environment
The physical appearance of business premises may decline as a business slips into financial distress. Upkeep and maintenance may move down the priority list as the directors fight fires elsewhere in the business. This decline is likely to be a gradual process but be obvious to stakeholders that only visit occasionally. The confidence of stakeholders, such as customers and suppliers, will have a bearing on the prospects of the business.
The other key stakeholders in a business are its employees. These are the people who attend the premises weekly and their morale can greatly affect the performance of the business and the likelihood of turning a business around.
Director disputes and / or senior personal departures will negatively affect the business environment and the further down the road of decline a business the more likely that the people who could had driven change within the business would have sort out opportunities elsewhere away from the chaos.
Poor relationship with financiers
A company’s solvency is not limited to the cash resources immediately available to pay debts. Hence, understanding what money can raised by way of debt or equity injections is a key consideration in assessing solvency.
In terms of funding and finance, red flags that could trigger a conversation about the risk of insolvency include:
- Inability to seek further funding from current financier
- Rejection of request to rollover a facility
- Unable to refinance with alternative financier
- Funding obtained with costs well in excess of market rates, and
- Due diligence by investor raises concern about business model or that balance sheet is beyond repair.
Inability to pay taxes when due
As cash flow dries up, decisions may need to be made on which creditors are paid. A supplier’s behaviour can have a greater bearing on the company’s ability to trade in the short term and therefore the squeakiest wheel often gets the oil first.
Inevitably this means that when taxes become due, payment is moved down the priority list. The first instance of deferring statutory debts is something liquidators look for when assessing solvency and this should give Directors pause to think about the long-term viability of their business.
Although statutory creditors may have limited leverage in affecting operations in the short term, rarely does the ATO accept haircuts to their debts. Consequences of non-payment can include public disclosures of arrears by the ATO making it more difficult to obtain credit, garnishee notices, Director Penalty Notices, and disqualification from safe harbour protection.
Legal action will be the last step in creditor disputes and often, due to commercial considerations, disputes will not escalate beyond informal demands and negotiations. Liquidators understand this and will not just look for formal legal disputes to assess the point in time that a company may have been insolvent.
Suspicions of insolvency should be raised upon the occurrence of:
- Significant aged creditor ledger
- Creditors stopping of supply or implementing cash upon delivery terms
- Material changes of terms and rates to recoup losses, and
- Special payment arrangements with creditors.
If disputes are escalated to formal legal action, this becomes publicly available information which is collated by credit reporting bureaus. This could exacerbate distress as obtaining credit and dealing with stakeholders becomes more difficult as the market becomes informed on the potential solvency risk.