By recognising the warning signs of insolvency and implementing strategies to minimise risks, accountants, owners and managers may potentially avoid business failure and take steps to minimise personal risk.
To determine whether a business is insolvent, a number of factors must be considered. Accountants, owners and managers need to assess their solvency and the following factors should be considered when making that assessment.
1. Business aesthetics
Not all indicators of insolvency may be found on a spread sheet. A tell-tale sign may be the ‘look’ of the organisation itself. A prosperous business is in a position to spend more on the upkeep of its premises. It stands to reason that if a business is struggling, it will not be able to divert funds to the maintenance of its premises.
Similarly, employees may provide an indication of the business’ success. Staff are usually aware of how successfully a business is operating, and their mood can reflect this. For example, a successful business may have happier, more productive employees, while staff morale would be low where a business is struggling.
2. Insufficient and inaccurate books and records
Section 588E(4) of the Corporations Act 2001 (Cwlth) states that “if a company does not keep comprehensive and correct records of its accounts and financial position, or if it does not keep records of a transaction for seven years after its completion, then that company will be presumed to be insolvent during the period to which the records relate.”
During tough times, owners and managers of a business may not focus on maintaining their books and records however, it is essential that these be maintained to avoid the statutory presumption of insolvency.
3. Forecasts and plans
Every business requires a detailed budget and cash flow for the coming financial or calendar year. Without these, business operators are unable to monitor results or make useful planning decisions. Any budget and cash flow must be based upon a logical and informed interpretation of data.
4. Dishonoured payments
Withholding of payments to creditors, bounced cheques and dishonour fees are good indicators of a business’ inability to keep up with payments when they are due and payable, or within the terms of trading agreements. This may be symptomatic of a business that is struggling to make ends meet, particularly where such payments are related to unpaid taxes or other statutory liabilities.
5. Increased aging of creditors
Any overall increase in the time that it takes to make payments to creditors can indicate that a business is struggling financially and may have limited cash flow to meet payment obligations.
In this situation a business may prioritise paying some creditors over others with large lump-sum payments, or choose which creditors to pay on time and which to pay late, depending on its need for the respective supply. These strategies may suggest that a business has had to ‘tighten its belt’ by restricting available funds and making payments to essential suppliers first to maintain trading operations.
6. Altered credit terms
When a creditor’s payments are continually delayed, creditors may respond by altering their trading terms with a business. For example, a supplier might reduce trading terms, enter into a payment plan to enable the business to pay an overdue account, or place them onto ‘cash on delivery’ terms until any outstanding amounts are satisfied.
These actions indicate that a business is no longer able to satisfy its debts as and when they are due, and that it is clearly experiencing financial difficulty.
7. Delay of tax payments
As detailed above, businesses with limited available funds may choose to prioritise certain payments over others. This might include paying the most essential supplier first. Often, payments of statutory taxes such as PAYG and GST are delayed as they do not immediately affect the operations of a business. In the short term, this delay may improve a company’s cash flow.
Recent amendments to the Director Penalty Regime (see Summer 2012 Client Information Bulletin) mean that directors may be held personally liable for outstanding PAYG withholding tax, should the amount have not been reported and be in excess of three months of the date on which it was due.
Consequently, non-payment of such tax by a business would be considered a strong indicator of insolvency. A business may enter into a payment plan with the ATO to repay PAYG tax, which only confirms insufficient cash to meet business debts as and when they fall due.
8. Delay of superannuation contributions
In an effort to improve short term cash flow, a business may delay the payment of its employee superannuation contributions. As these contributions are usually paid quarterly, overdue amounts may not be recognised as such until some time after the due date.
As with delayed tax payments, delayed superannuation contributions may indicate that a business is struggling to manage its cash flow. The amendments to the Director Penalty Regime mean that the director of a company may now be held personally liable for unpaid superannuation contributions in certain circumstances. Consequently, non-payment of superannuation contributions by a business would also be considered a strong indicator of insolvency.
9. Bank overdraft limit reached
An indicator of insolvency is whether a business regularly trades at or close to its overdraft limit. If a business regularly trades at its overdraft limit, it means that there will be little to no emergency funds available should they be required.
10. Legal action
Legal action issued against a business will result in the business incurring the financial cost of defending any claim. This would impact future cash flow and should be taken into account when preparing budgets and cashflow forecasts. Obviously, unsatisfied judgments which have not been appealed would indicate insufficient cash flow to satisfy debts as a when they fell due.
If a business is faced with one of the following three things it would ordinarily be considered insolvent:
- a winding up notice
- a statement of claim relating to unpaid accounts
- being issued with a director penalty notice.
If you are seeing these warning signs talk to your Chartered Accountant to discuss the options.