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01 Mar 2010

Not-So-Obvious Indicators of Insolvency

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5 min

Starting back in August 2004 we wrote a three part article on the 2003 decision of ASIC v Plymin. That decision was notable as the Judge listed 14 Indicators of Insolvency that he used to determine whether the company was insolvent and whether the directors should have suspected so. Our first three articles on the topic listed those indicators, what they were and what they meant to insolvency practitioners.

We followed that series up in April 2008 starting a four part series about the indicators. In that series we stated that the indicators could essentially be grouped into three groups:

1. Those based on financial statements - indicators related to the paperwork and the information available from that paperwork;

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.

2. Those based on cash flow - indicators related to the availability of money; and

Insolvency is an inability to pay debts when they are due, so factors that indicate the availability of cash to do so, or the lack of it, become important. Insolvency must be distinguished from a short-term cash flow problem, so these indicators look at factors affecting cash flow, as well as the availability of cash at any one moment in time.

3. Those based on relationships with creditors etc - indicators related to dealings with creditors and what signs should be noticed from these dealings.

Regardless of the business structure, a lot of business is done by people dealing with people and the relationship between the parties will dictate how business is conducted. Strained relationships often lead to or come from a strained business. Business owners can get an indication of the health of their business from the health of their relationships with the people they do business with.

Some of the indicators were so closely related that we could combine them and in 2008 we produced a revised list of them as follows:

Financial Statement Indicators
Continuing losses and working capital
A lack of timely and accurate financial information

Cash Flow Indicators
An inability to raise equity or loan capital
Issuing post-dated cheques or having cheques dishonored
Payments in rounded sums and for a minimum amount
Overdue Commonwealth and State taxes

Creditor Relationship Indicators
Poor Relationship with Bank
Suppliers demanding COD trading, or payments before supply
Creditors issuing demands or proceedings

I do not intend to reproduce that paper here. They can be accessed through the Insolvency Articles archive on our website.

These indicators became relevant last month as I was preparing an affidavit for the recovery of a preferential payment, and that affidavit included detail of the solvency of the company or in this case the lack of it.

The company was wound up in October 2009, six years after the Plymin case and the publication of the list of indicators. But still this company displayed nine of the 14 indicators:

Continuing losses
Liquidity ratios below 1
No access to alternative finance
Inability to raise further equity capital
Suppliers placing [company] on COD, or otherwise demanding special payments before resuming supply
Creditors unpaid outside trading terms
Special arrangements with selected creditors
Solicitors' letters, summons[es], judgments or warrants issued against the company
Payments to creditors of rounded sums which are not reconcilable to specific invoices.

Even though these indicators were present, the director appears to have been ‘unaware of’ or at least ‘unable to accept’ the possibility that the company was insolvent for many months before it became so obvious (the company simply ran out of all money and wages could not be paid the next day) that he had to make an appointment.

While one isolated case may not be significant, it is surprising the number of directors that we speak to that only have come to the realisation that their company is insolvent, or made the decision to discuss it, well after a number of these indicators would have strongly suggested the company was insolvent for some time.

There are two obvious possibilities. One is that the directors are totally unaware of the position of their company and have no idea of what may indicate insolvency. Undoubtedly there are a few that fall into that category, but would be the minority.

The other is that, albeit they realise that there may be a problem, they ignore the indicators. They believe or hope that issues will resolve themselves before defeat has to be admitted. Human nature what it is, people do not like to publically admit defeat. Unfortunately, this usually means that by the time that help is sought it is often too late.

In a few cases, directors see these indicators and start to take remedial action. Even if they cannot save the company, they still may be able to avail themselves of protection from an insolvent trading liability - as in the case of The Stake Man (see The Stake Man gets off in this e-Update).

The indicators should be of great assistance to business owners. While not conclusive, these indicators should start business owners asking questions and making enquiries. On the other hand, the business owner should have some comfort if all of these indicators are positive, while realising that they will not give any guarantees of success and solvency.

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