Last month we started a series of articles on Indicators of Insolvency. This month we look at Financial Statements Indicators.
Financial statement indicators relate to the information that is available in the business’s books and records – or the lack of that information. Financial statements should provide sufficient information for business owners to determine the likelihood of insolvency, but in many instances financials are either not produced or the results are ignored.
Continuing losses and working capital
Making losses is a signpost that should alert business people to the possibility of insolvency. Not every business that makes a loss, or even a series of losses, is in danger of becoming insolvent. As long as working capital resources are available to absorb the losses, insolvency can be avoided or at least delayed.
Insolvency is brought about by a combination of losses and insufficient working capital. So, if losses are continually incurred, working capital will eventually be depleted. Business owners have to consider the available levels of working capital, and the extent and timing to which working capital might be depleted. Many small businesses do not have much working capital and even a short run of losses will deplete any resources and eliminate any capability of continue to trade.
Working capital is the difference between current assets and current liabilities (usually measured by a liquidity ratio), but cash flow and whether the business has the ability to pay its debts is the final arbiter of insolvency. Working capital must be able to be turned into cash to meet debts, so a liquidity ratio greater than 1 may not prove solvency.
Business owners need to be able to monitor working capital to determine whether it reduces below a critical level, and whether there are sufficient liquid assets to pay debts.
A lack of timely and accurate financial information
This is arguably the weakest of the indicators when viewed objectively, but subjectively it provides an indicator of the likelihood of insolvency. We can conceive of a solvent business that is unable to prepare accounts in the short term for a variety of reasons. But sound, solvent businesses of any size will be able to produce accurate financial statements in the long term.
From a subjective view point, experience shows that insolvency and having financial records in disarray often go hand in hand. Not only do insolvent entities almost always display inadequate accounting records and a complete lack of reasonable forecasts, they also frequently demonstrate a reluctance to prepare reliable and timely accounts. People do not want to get bad news.
Many business owners do not prepare regular management reports and even then pay little attention to the information produced. Many SME owners use external accountants for little more than preparing ATO and ASIC returns and as a registered office, and see financial statements as not much more than an attachment to income tax returns. Very few owners of insolvent SMEs can lay their hands on anything more than last year’s – or the year before – tax returns and a copy of the MYOB back up.
Without regular financial information business owners will not know the financial position of the business. They will not know the extent of losses and the levels of remaining working capital. They will not be able to convince bankers or other creditors that there is a solution to any cash shortage they may face – compounding problems highlighted in other indicators. Without adequate and understandable information, business owners will simply not know whether the business is solvent or not. This is something they need to know.
Next month: Cash Flow Indicators