Insolvency and Financial Distress

How to Avoid it and Survive it

Brian A. Finch

• Publisher: A&C Black Business Information and Development
• Year: 2012
• Print ISBN: 9781408151457
• eBook ISBN: 9781408153963
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

Avoiding insolvency is a key challenge for any business: even in good economic times, one in three small businesses goes bust every year, and in the current fraught climate, companies of all sizes are facing financial distress. According to the UK government's Insolvency Service, in the first quarter of 2011 alone, there were over 4, 000 compulsory liquidations and creditors' voluntary liquidations in total in England and Wales.

In this book, Brian Finch offers information and advice for people connected with businesses in financial distress. The main aim is to avoid insolvency wherever possible or to otherwise mitigate the pain involved.

The book tackles crucial issues such as:

• Spotting warning signs early on
  
• Understanding bankruptcy and its alternatives
  
• Dealing with practical problems
  
• Understanding the implications for directors
  
• Starting over

Chapter 1
Knowing you have a problem

First of all, it’s crucial to recognise that you have a problem. There are four indicators that reveal a company is in choppy financial waters:

1. you are finding it hard to pay your bills on time;

2. you produce forecasts that show a cash flow problem in the future;

3. you have a weak balance sheet, probably with a negative value;

4. you know there is a risk of your financiers withdrawing support.

The first of these demonstrates an immediate problem and is instantly recognisable. It comes in two flavours: ‘legal action’ and ‘not yet’.

Legal action

The ‘legal action’ test is a pretty clear indicator where one or more creditors has:

• obtained a county court judgement against you;

• issued a statutory demand (for more than £750) that remains unpaid after 21 days;

• started proceedings to wind up your company.

There were more than 200,000 county court judgements obtained in 2006, which demonstrates that suppliers are quite ready to use this mechanism to force customers to pay their bills. Since levels of company liquidations in that year were 18,000 across the UK, it is clear that a judgement does not necessarily mean that a company will fail. If the judgement is not paid within 30 days, however, the creditor can go back to the court and seek a winding-up petition against the company — so the county court judgement tends to concentrate minds on paying the outstanding debt.

A statutory demand is a formal document issued by a creditor, demanding payment. It involves no immediate cost to the creditor, who can easily download an example from the Internet. It constitutes an enhanced threat — it strongly implies the issue of a winding-up petition if the debt is not paid immediately [see page 176] and creates a legal presumption of insolvency.

These legal steps will often follow equally obvious warning signs: you’ll no doubt have received final demands for payment, have been refused further supply, or had your account referred to a debt collection agency. The threatening letters are just one step before the strict legal test and it’s important to take action at this stage, while there is still time.

‘Not yet’

The early signs that I have called ‘not yet’ are really where you need to review the situation of the business and take remedial action. You have not yet received notice of legal proceedings but you are well on the way there. You find yourself stretching some suppliers’ credit terms in order to pay others — and these suppliers may include your landlord or HMRC. You may just delay sending out the cheque for a few days, perhaps making sure it is posted just before a weekend to give you a few more days before it clears. But isn’t this normal, doesn’t everyone do it? The answer is a matter of scale and duration: if creditors are substantially stretched and it happens every month, it is decidedly not normal. There are three things you can do to assess whether there is a problem:

1. List all your delayed payments and add up the total.

2. Make an estimate of the average delay.

3. Check what your minimum bank balance was during these few days of delay.

The results will give you a good idea of whether you have a problem and how big it is. Let’s say you delayed paying £50,000 for a week after the month-end; and suppose you have a bank overdraft facility of £50,000 which was used to the extent of £45,000 during the first few days of the month. That is good, isn’t it? You had £5,000 of your bank facility unused. No, it is not good because you used most of the bank facility but did not pay £50,000. That means you are short of the £50,000 you did not pay, less the £5,000 of unused facility — leaving a hole of £45,000 full of debts you could not pay when they fell due.

Maybe you have become so used to delaying payments that it has come to seem normal. It isn’t. Most businesses have some variation in their cash flow, either as a result of seasonality or paying rent quarterly. Make sure you do this exercise around the rent quarter day so that you see the worst case.

If this exercise shows that there is a continuing cash shortage, there is one more step to take. Ask yourself:

• Is the problem getting worse?

• Are creditors getting annoyed about the persistent delays?

If the problem is getting worse, you can’t just struggle on: a crisis point will come eventually. So it’s ok if it’s not getting worse? Well… maybe… but, you can pay a week late, every month, for years and then find the suppliers suddenly say ‘no more!’. Believe me, I have been there. If you are close to the edge and one supplier who you have been paying, say, £5,000 a month (but a week late) for years suddenly gets awkward or changes their credit controller and the new person says ‘no more’, where does the extra £5,000 you need come from?

The second point on the list of indicators that show you may have a problem is the forecast. This tells you there will be a future problem that may be days, weeks or months away but it represents a hole that needs some action to close. Just because it is possible to think of many ways of addressing the issue does not remove the problem. Which of these actions will you take and when? In particular, adjusting your forecast assumptions to close the hole, is not (necessarily) a solution. It is too easy. If your first set of assumptions was arrived at with care and consideration but produced a result that you, or someone else, did not like, then adjusting those assumptions threatens to replace a realistic view with wishful thinking — which is dangerous in business.

What about having a balance sheet that shows a deficit — this means your liabilities are bigger than your assets? This is a probable sign that you won’t be able to pay your debts at some time in the future but that may not be absolutely certain. You probably need advice. The company may be kept alive by a loan from a director or shareholder. As long as this is not withdrawn, the company is not insolvent, regardless of the balance sheet deficit. Or it may be that the value of some assets in the balance sheet are understated, or there is a reasonable likelihood that a new project will rectify the deficit. Give yourself a moment to think about the opposite problem — suppose the balance sheet looks ok but you know there are some assets there that are not really worth the stated value. This may be stocks that you know you will never sell, or debtors who are never going to pay, or a machine that is actually redundant and worth nothing, or a property that will never find a buyer, or an intangible asset (this may be goodwill arising from an acquisition or be the value of a brand name or a patent etc.). Adjust these values to something you think more realistic: how does the balance sheet look now? If an intangible asset in your balance sheet is what stands between solvency and insolvency, get advice from an accountant.

The fourth indicator of a serious problem — fear of withdrawal of banking facilities — is really just a special case of a forecast assumption that we discussed above, but is so important that it deserves a separate category. Normally any executive of a business that has bank borrowings will, as a matter of course, assume the bank will continue to lend, but what if they don’t? It is most likely to prove a problem when the business has or expects cash difficulties or where the balance sheet looks weak. Any of these may prompt a lender to decide the risk is too great and to withdraw facilities. Most companies, from the biggest to the smallest, from the successful to the struggling, will cease to trade if their bankers withdraw facilities. Of course big, successful companies will usually find other bankers or alternative sources of finance in time to prevent insolvency. Smaller companies may find this harder. Of course you can’t spend your life worrying about what the bank may or may not do at some point in time. You should reserve your worrying to periods when you know there is a credit crisis affecting banks or if you know that your trading or balance sheet will concern the bank manager.

Should company directors worry about economic conditions or a banking crisis that they can’t do anything about? Sure, if this will affect the wellbeing of their business. Credit crises come pretty regularly — maybe every ten or twenty years, certainly once in a working lifetime. It is not as though they are a once-in-a-thousand-year phenomenon. And there are things the individual can do about the potential problem even if not about the economy.

The letter from your accountant

There is another indicator of trouble that I have not included in my list, which is the letter from your external accountant (or, equally, a memo from an internal accountant) that tells you there is a problem. I haven’t included it because they, in turn, will have relied upon one of the four indicators I have listed. Nonetheless, this deserves a mention.

The letter from your accountant may follow work on an audit; they may be warning you that they will not be able to give a ‘clean’ audit opinion or the fact may simply come out of the blue. Any letter of this kind that does not follow a discussion, either in person or over the telephone, is likely to result from someone wanting to ‘cover themselves’ if things go wrong. They have assessed that the balance of business risk has got worse and could have repercussions for them, so they want something in writing to show they performed their duty and gave due warning.

This is a moment for calm. It may just represent an insurance policy for the writer but it does put the directors in a difficult position. The letter must be read carefully, its implications discussed with the writer and its content must be communicated to the board. The board must discuss the matter and its discussions must be minuted so that, in the event of later liquidation, there is a record that the warning was taken seriously and appropriate action taken. This is a defence against an accusation of wrongful trading. The actions of the directors will depend upon whether the letter warns that the company is insolvent or just that there is a risk it is heading that way. Accepting the message is only one option — the board can decide that it is patently wrong, or it can seek advice from another accountant or from an insolvency practitioner. If the board concludes that it is reasonable to believe that the business can continue as a going concern, their hand is not necessarily forced by the letter. But if that conclusion is unreasonable, they do risk legal action for wrongful trading if they continue trading and the business subsequently goes into liquidation.

The audit opinion

An external audit of the financial accounts is no longer required for smaller companies² but many still have one, to reassure outside investors, or the bank or even suppliers. Auditors supply a statement for inclusion with the accounts that, amongst other things, gives an opinion that the business is a ‘going concern’. Such an opinion can sometimes be qualified. In an extreme case it could say that the going concern status is not appropriate but that rarely happens because the directors would have to call in administrators before issuing such accounts. Other qualifications may refer to fundamental uncertainty, perhaps arising from inadequate records or to some significant degree of uncertainty or risk. A common comment in the audit opinion of a private company relates to continuing financial support from the bank or from a key investor.

A qualification to the going concern opinion may have no effect if it just draws attention, say, to a company’s reliance on an investor continuing their loan. However, a new qualification that indicates some doubt over the going concern status can be a bombshell similar to the accountant’s letter discussed above. It would require the directors to think very carefully about prospects for the business and about getting advice. It would also have a big effect on bank lenders and suppliers (or credit insurers) when they read it. Unless the directors believe they can put forward a persuasive case to convince these parties to continue supporting the business, some radical action would be needed.

Common causes of financial distress

So what causes these problems? While there are many detailed possibilities, we can usually group them into just three categories:

• Overtrading

• Long-term weakness

• Sudden shock to the system.

Overtrading

Even profitable and successful companies with a big future may find themselves short of cash as a result of their success. This is called overtrading. It results from the simple idea that a growing business needs to invest in working capital to support that growth. This may be in the form of extra stocks, work in progress or debtors that all grow as sales grow but usually do so before enough profit rolls in to finance them. If your sales are growing and you are making profits but are increasingly short of cash, you are probably overtrading. In this situation you only have two choices:

1. cut back your growth so you can live within your resources;

2. raise extra capital or borrowings to finance your growth.

Actually, there is a third action that is an alternative to limiting your rate of growth. You can raise your prices, perhaps only on these ‘extra sales’ that you struggle to finance. If you are able to do that, the extra profit will either fund growth or will make the business look more attractive to a bank so that it may be willing to lend more.

No, you say, we can delay a payment here a...

Table of contents

• Cover Page
• Title Page
• Contents
• Preface
• Introduction
• Chapter 1: Knowing you have a problem
• Chapter 2: Dealing with the stress of financial distress
• Chapter 3: Avoiding Insolvency
• Chapter 4: Practical Problems
• Chapter 5: Alternatives to Insolvency
• Chapter 6: Types of Insolvency and terms used
• Chapter 7: Using administration to save your business
• Chapter 8: Implications for Directors
• Chapter 9: Starting Again
• Chapter 10: Practical steps for investors, creditors and employees
• Chapter 11: Buying from an administrator
• Chapter 12: Getting help
• Acknowledgements
• Glossary
• Footnotes
• Imprint