Last month we started looking at some of the practical signs of insolvency. These are signs that should be noticed by business owners, their advisors or friends, when financial difficulties arise. This article was brought about by two factors: (1) the 14 indicators of solvency as detailed in the Plymin case; and (2) the fact that many business owners still do not recognize these indicators and fail to take proactive action in a timely manner.
Last month we looked at Denial and Avoidance as the first such sign. We continue this month ..
We see this sign in just about every liquidation or bankruptcy. During the GFC in particular, but in any type of economy, many business owners in financial difficulty treat the ATO as a lender of last resort. Gone are the days when cash strapped businesses had to turn to the business equivalent of loan sharks to get short term funds. They simply used the government.
It was apparently quite easy to obtain a “loan” from the ATO – done simply by not paying tax for a while and then making a phone call to an automated service to arrange a payment arrangement. Rarely was it actually that easy, but the principle of using the ATO as an easy source of cash flow is and has been a common occurrence. Not only was the loan easy to obtain, it came with competitive interest rates.
Such activity is a clear sign that, at the bare minimum, a significant cash flow problem exists. But more likely it is a sign of an insolvency problem, particularly as the debt gets older and the monthly or quarterly returns are no longer lodged. Business owners – and their office staff and advisors – should have been well aware that the business could no longer pay these statutory imposed debts when they should be paid. This sign is not hidden amongst complex accounting principles or procedures.
The days of easily getting a ‘loan’ from the ATO appear to be coming to an end. Last month we ran an article on the planned changes to the Director Penalty Notice regime and we noted that we had seen a sizable increase in the number of DPNs being issued. It looks like the ATO is collecting their loans, and getting new ones will likely prove more difficult.
Continued trading losses
Working capital is a finite resource and allowing losses to continually eat it away is a recipe for disaster. Continued trading losses eventually lead to insufficient working capital to maintain the solvency of the business.
Losses themselves would be noticeable, if the business owner is preparing (or having prepared) regular profit and loss management accounts which, unfortunately, many do not. Losses should be suspected if cash flow dries up and there is no other reasonable explanation for the shortfall, and this situation should lead to profit and loss accounts being prepared to find the problem. The major factor here is the production of regular accounts. Many businesses who do not produce them have to wait for other signs that they are running at a loss.
The lack of working capital caused by losses should be evident when business owners have to start injecting their own money into the business to pay bills. This is usually done on an unsecured basis and exposing personal assets. The unfortunate thing is that they may just be (as the saying goes) ‘throwing good money after bad’. But this should be a sign that something is not right – whether trading at a loss, insolvency, bad record keeping or a lack of financial information.
Continued losses leads to insufficient working capital – and that manifests itself in a lack of cash. One major indicator of a lack of cash is having cheques being returned unpresented, or having to issue post-dated cheques – some of which will probably be returned un-presented in the future. The sign that we generally see (well after the cash flow problem turns into insolvency, and insolvency turns into liquidation or bankruptcy) is the proverbial draw full of cheques waiting for sufficient funds to be able to release them. And maybe then only being released when a creditor yells loudly enough.
Creditors who do not get paid, who receive cheques that are dishonored or who receive post dated cheques generally become very cautious about granting further credit. This can cause the business owner to start “shopping” for new suppliers. New suppliers may issue credit for some period keeping a continuity of supply. Then the cycle starts again.
The continued inclusion of new suppliers is a sign that the old suppliers are not willing to supply for some reason, and that reason is probably because they are not getting paid.
The Blame Game
The Blame Game is the next step to the Denial and Avoidance sign mentioned last month. It occurs when the problems can no longer be denied or avoided. It then becomes everyone else’s fault. Well: ‘It is certainly not my fault’.
Some people cannot accept that they had anything to do with whatever problem has arisen. In their eyes it is the other people who are unreasonable.
- Creditors are being demanding – but who wouldn’t be when they’re not being paid?
- The debtors won’t pay – but is anyone following them up, and are they actually getting what they are being asked to pay for – or is service slipping?
- The bank won’t extend the overdraft – could it be that, because the business owner was in denial, they haven’t received the quarterly financials that they’ve been requesting for the last 4 quarters.
- The ATO actually wants us to pay our taxes.
Advisors, staff, family and friends of the business owner will be the ones to see this sign. The business owner himself will not. Once this point is reached, there is little chance of working the financial problems out unless someone else steps in and takes control, or makes the business owner see sense and accept that the best chance of a resolution lies with him or her.
Where does this lead?
Inevitably, cracks start to appear in the relationships of people operating under continuing financial pressure. This may show itself when the “other” spouse seeks advice independently, or when the husband and wife suddenly have different addresses. It also shows as staff, particularly senior staff, start to leave because they cannot work under the pressure anymore, or do not believe that there is a long term future with the business.
The common denominator with all of these signs is the reluctance on the part of the business owner to accept that all is not well and take remedial action. The businesses that can be saved are those that are treated early enough- and that is commonly the problem. Once these signs are obvious enough for some business owners to see, the light at the end of the tunnel is actually the on-coming train.
Usually by the time it is all too late, there is no working capital left, the creditors will not consider any moderation in their terms, the directors are no longer speaking, let alone sleeping together, and the business becomes one of our files.