Signs and indicators of insolvency

COVID measures created a false level of comfort around mounting debts.

Insolvency is rarely something that happens overnight like your overnight oats or pizza dough. It is multiple factors accumulating over time, leading to an endemic shortage of working capital and inability to pay debts as and when they become due and payable. Consequently, assessing a business’s insolvency is necessarily a constant and ongoing analysis for directors and advisors.

Many businesses out there may be currently awash with cash—which could be a combination of stimulus monies, new-found cash flow as lockdowns eased, deferral of debts, or capital injections. However, this could be a false sense of security if that business is also harbouring debts accumulated before or during COVID. 

How so? Well, many readers know of the material decline in insolvencies since COVID hit Australia’s shores in early 2020. This was artificially created primarily by lockdowns, stimulus monies, and significant government intervention. Some key government interventions included temporary changes to statutory demand and bankruptcy notice thresholds[1], rent relief schemes, and a temporary relief from insolvent trading for directors.[2] Banks also rolled out a significant COVID relief program. 

The result of all these measures on businesses harbouring material debts was the Australian Taxation Office (ATO), landlords, banks, and other creditors significantly reduced the repayment/payment pressure or that pressure altogether dried up. However, with all these COVID measures now largely removed, businesses must deal with their debts once again and, importantly, assess their ongoing viability. 

Warning signs of insolvency 

Of course, some signs of insolvency are obvious—such as having insufficient resources to pay employee, tax, and other creditor debts which just keep on piling up. But others are far less obvious and can be a slow burn overtime, more often collectively leading to a business becoming insolvent—such as ongoing director disputes, poor record keeping, or a trend of losing customers. 

Below is a list of some of the more common warning signs of insolvency, broken into four groups. 

Financial statement & records indicators

• Continuing trade losses and diminishing / insufficient working capital.

• A lack or inability to produce timely and accurate financial information, including budgeting and strategic planning.

• Poorly kept books and records.

Cash-flow indicators

• Poor or no cash flow.

• Inability to collect debtors in a timely manner and bad debt write-offs.

• Overdue Commonwealth and State taxes, or long-outstanding taxes.

• Inability to pay staff wages / super.

• High and increasing gearing (debt to equity).

• Increasing trend of trade creditor balance.

• Making payments in rounded sums and for a minimum amount.

• A need to enter into payment arrangements with creditors.

• An inability to raise equity or loan capital, including from related parties.

• A reliance on external or related party funding rather than revenue generation from sales.

• Issuing post-dated cheques or having cheques dishonoured.

 Creditor relationship & external indicators

• Suppliers demanding cash on delivery (COD) trading, or payments before supply.

• Creditors issuing demands or legal proceedings.

• Outstanding tax lodgments.

• A trend of losing customers / clients.

• Poor relationship with the bank, landlord, or key suppliers.

Management & internal indicators

• Director and / or shareholder disputes.

• High staff turnover.

• Denial, avoidance and ‘the blame game’ by directors and management.

• Poor upkeep of business premises and plant & equipment.

• A lack of corporate governance or poor compliance.

• Inability to invest in staff development, IT, and other business systems and processes.

In recent months several business owners/directors have sought our advice when the above warning signs started to show. As a result of this quick action, several companies could undertake a restructuring process via either the small business restructuring (SBR) process[3] or a Deed of Company Arrangement in the voluntary administration process (VA to DOCA).

The SBR and VA to DOCA processes allow directors to develop a plan to pay off a company’s liabilities, in full or in part. Those advisors’ and directors’ proactive approach gave them an opportunity to restructure their business.

The key takeaway for directors and advisors is that now the ATO and other creditors are recommencing debt collection activities, it is important to know and understand the warning signs of insolvency and if identified, act quickly. This may save a viable business via formal restructuring processes under the Corporations Act 2001.

Worrells has been helping people and businesses dealing with financial stress for over 49 years. Contact your local Worrells principal for a complimentary and confidential discussion.

[1] For statutory demands (corporate): the amount that must be owed was increased from $2,000 to $20,000 and the timeframe to respond/pay was increased from 21 days to 6 months. For bankruptcy notices (personal): the amount was increased from $5,000 to $20,000 and 21 days to 6 months. These temporary amendments ended on 1 January 2021. The statutory demand thresholds reverted completely, but then on 1 July 2021 the minimum debt amount was permanently increased to $4,000. The Bankruptcy Notice threshold reverted to $10,000 and 21 days, not the pre-COVID $5,000 and 21 days.

[2] The temporary relief from insolvent trading for directors ceased on 31 December 2020.

[3] More information on the Small Business Restructure process can be found here: Small Business Restructuring and Small Business Restructuring criteria.