When a business gets into trouble it is important to ensure that the company, and by extension the directors don’t wrongfully trade but there are some ways of surviving insolvency that could be useful if your company is in difficulties.
Insolvency put simply is where a business has no prospect of paying its debts when due. It is important to note that insolvency really has little to do with whether the company is profitable or not. Insolvency is more a function of cash flow and if a company does not have the cash to pay its bills then it will likely be insolvent. To check your position, you might want to use our company liquidation assets/liabilities tool available from our home page
Legally there are in fact two definitions of insolvency; the’ balance sheet test’ and the ‘cash flow test’.
The first of these; the balance sheet test relates to the case where a company has total liabilities that exceed its total assets. Whilst this may seem an academic accounting test, in fact it has direct implications for any supplier who provides goods or services after the point of insolvency because it means that in the case of liquidation they are unlikely to receive their money.
The simpler of the two is the cash flow test. This is where a company does not have enough free cash to pay its creditors when their invoices become due. It doesn’t describe very short term cash shortages but more a structural problem with meeting obligations.
Staving off, and subsequently surviving an insolvent state is possible but the effects on both of these tests have to be borne in mind before taking any course of action.
Let’s take the easiest way to save a company from becoming insolvent; injecting capital. This essentially means that the directors or an outside shareholder buys more shares for cash. In this case this can solve the insolvent state in both definitions.
In the case of the balance sheet test, providing enough shares are bought for a large enough sum then the asset base of the company will increase as money will be put into the bank account. For the cash flow test, clearly the additional cash injected can then be used to pay creditors. Of course it is important to make sure that you do not fall foul of any share sale legislation especially if you sell to an outside investor.
The injection of capital will be pretty pointless if the underlying business is unprofitable, as the company will soon use up the cash input.
Raising cash by selling assets may seem like a good idea however it can actually make the issue worse. Often assets are carried on the balance sheet at a value higher than the possible sale value of the asset. In this case selling some assets may help with the cash flow test but would make the balance sheet test result worse. Directors considering this should look for assets that have been fully written down to realise cash but must not sell for below market value and must conduct an arm’s length transaction in case the company goes into administration later as charges may result.
If the firm is only facing temporary cash flow difficulties then there are some ways of surviving what may be a short term effect. As mentioned previously asset sales can help, as can factoring invoices for short term finance and where possible increasing loan facilities but the directors should be certain that the cash flow issue they have is actually short term in nature and not a result of poor trading.
Leading and lagging is an option. Leading is where companies attempt to collect debts early, sometimes through the offer of early settlement discounts to bring cash through the door quickly. The company should also consider whether it is granting its customers too generous terms. If the firm gives customers too long to pay then it is in effect financing someone else’s’ business and reducing the cash flow in its own.
Lagging is the practice of taking a little longer to pay creditors. In some cases the creditor may not notice but it is always preferable and good practice to agree longer payment terms in advance with suppliers to ensure continuity of supply. Again this is of no use if the underlying business will still be cash poor in the near future and should only be used for very short term problems.
One of the biggest users of free cash is excessive inventory. Holding too much stock means that companies are obliged to pay creditors for supplies before the goods are even sold. This means that cash that should be available to pay debts is actually sitting on a warehouse shelf. Look to reduce inventory and run sales on a leaner basis such a Just in Time (JIT) or drop shipping directly from the supplier to the customer.
Firms should always look at their method of financing and try to match the finance with the type of asset it relates to. For instance short term financing shouldn’t be used to purchase buildings as not only will it be more expensive it will tend to skew accounting ratios such as the acid test in a negative way. Look to switch short term sources of finance such as overdrafts to longer forms like mortgages, debentures and long term loans. Best of all get equity investors on board.
Finally if all avenues have been tried and found unsuitable then the directors can look to effect a pre-pack, where the business and the ‘good assets’ are bought out of an administration. It Is not ideal but handled correctly by a qualified and experienced insolvency practitioner it can be a method of ensuring that the firm actually survives insolvency after all.
When a business gets into difficulties it can be tempting to hope it will all go away but taking some of the steps above quickly can ensure that the business is better able to avoid getting into an insolvent state and all of the problems that incurs.