Insolvency, a dreaded word in the business world, no matter how small or big the business is. But, by recognising the warning signs of insolvency, and putting in place some strategies to minimise the risks, accountants, owners and managers may potentially avoid business failure and also take steps to minimise personal risk.
It is important to assess the business solvency, whether of your own business, or of enterprises that your business liaise with, and the following factors should be considered:
1. Business aesthetics
You might think that indicators of insolvency are found only on spread sheets. Not exactly. Tell-tale signs may be the ‘look’ of the organisation itself. A prosperous business is able to spend more on the upkeep of its premises whereas if a business is struggling, maintenance of its premises may not be given a priority to divert its funds to.
Similarly, employees may provide an indication of the business’ success. Staffs are usually aware of how successful a business is, 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 may not focus on maintaining their books and records. But remember, it is essential that you don’t overlook in maintaining them 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. These are to help monitor results or to make useful planning decisions. Basis of any budget and cash flow should rely on logical and informed interpretation of data.
4. Dishonoured payments
Not able to pay creditors, bounced cheques and dishonouring fees are 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 all 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 payments to creditors are consistently delayed, the creditors may have to resort towards implementing harsher credit terms. For example, a supplier might reduce his trading terms, or enter into a payment plan to ensure the debtors pay up, or implement a ‘cash on delivery’ terms until any outstanding amounts are settled. These indicate that the business is no longer able to pay off its debts as and when they are due, and that it is clearly experiencing financial difficulty.
7. Delay of tax payments
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 states that directors may be held personally liable for outstanding PAYG withholding tax, should there be no report on the amount and there had been an excess of three months from the date it was due. Consequently, non-payment of such tax would be 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
Some businesses may delay the payment of its employee superannuation contributions to improve their short-term cash flow. Since these contributions are usually paid quarterly, overdue amounts may not be detected until sometime after the due date.
Similar to delayed tax payments, delayed superannuation contributions may indicate that a business is struggling to manage its cash flow. Hence the amendments to the Director Penalty Regime also apply, where the director of a company may now be held personally liable for unpaid superannuation contributions in certain circumstances. Thus, non-payment of superannuation contributions by a business would also be considered an indicator of insolvency.
9. Bank overdraft limit reached
Another indicator of insolvency is whether a business regularly trades at or close to its overdraft limit. Overdraft facilities are meant to be for emergency purposes, but if a business regularly trades at its overdraft limit that means it can no longer depend on its overdraft for any urgent cash requirements.
10. Legal action
Legal defence is costly. Any legal action issued against a business would incur exceptional costs and impact future cash flow. This should be taken into account when preparing budgets and cash flow forecasts. Obviously, when the business plans to appeal over unsatisfactory judgments, this will add to the business’ expenses, which would result in insufficient cash flow to satisfy other debts as and when they are 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.