Insolvency Warning Signs – cashflow is king

Financial Literacy

All directors must have some financial literacy in order to fulfil their duties and responsibilities to the company. This may be concerning for the directors and owners of small and family sized businesses as accounting and finance may not be their strongest attribute. However cashflow problems can arise unsuspectingly and it is crucial to identify when your business starts to struggle. 

The good news is that directors are not required to have infinite detailed knowledge of every transaction and are entitled to delegate and seek assistance in carrying out their duties – however, it is important to note that directors are ultimately responsible for the signing off of financial statements, reports and make other such declarations (re Centro case – ASIC v Healey & Others 2011 FCA 770).

It is critical for directors to be financially literate so they are capable of making informed judgements and decisions about the company. For example, directors will often need to:
1. review, understand and challenge any accounts prepared by management;
2. ensure there are appropriate internal controls and a risk framework in operation; and
3. have input into preparing the annual report.

Management Accounts – cashflow is king

• There is no strict format for management accounts, however, at a minimum, the management accounts should consist of the profit and loss statement, balance sheet and statement of cash flows. The accounts should allow for comparison between actual and budgeted data. 
• In particular, lack of cash flow can be terminal to a profitable businesses. Irrespective of whether budget lines are being met, unless you are managing your ongoing cashflow requirements, you are at grave risk of failure.
• Directors and management must agree a cash flow management system that is adequate for the business and it’s risk appetite. Cashflow is the single most important aspect to consider in businesses, ventures and projects – the moment you are unable to pay the ATO, key creditors & suppliers and the employees or subcontractors the stark truth is that your business is running out of options FAST.

Warning signs evident in the statement of cash flows include:

• Net operating cash outflows (negative operating cash flows).
• Payments to suppliers and employees are higher than receipts from
  customers.
• Net operating cash flows are lower than profit after income tax.
• A lack of self-generation.

As soon as you suspect your company may face financial difficulty, it is imperative to get advice as early as possible, as this increases the likelihood of a successful turnaround.

One of the most common reasons for the inability to save a company in financial distress is that professional advice was sought too late.

Insolvency: A guide for directors

ASIC Regulatory Guide 22 outlines the following factors that directors should consider in forming their opinion as to the company’s solvency:

• profit and cash flow forecasts;
• the organisation’s ability to realise current assets, particularly inventories and debtors;
• the organisation’s ability to meet suppliers’ credit terms;
• removal of financial support by major lenders;
• effects of contingent liabilities;
• availability of additional sources of finance; and
• the effect of future commitments.

Another useful resource is ASIC Regulatory Guide 217 “Duty to prevent insolvent trading: Guide for directors”.

The list set out below gives some of the warning signs of that you may face insolvency:

• ongoing trading losses
• struggling to manage cashflow
• lack of a business plan
• incomplete or inadequate financial records or poor internal accounting procedures
• lack of accurate cash-flow forecasts and incomplete budgeting methods
• continuing increasing of debt (liabilities exceeding assets)
• issues in selling stock, poor credit management or struggling to collect debts
• irrecoverable loans to associated parties
• creditors are being paid outside usual terms and are pressing
• legal letters, demands for payments, summonses, statutory demands, judgements or warrants issued against your company
• suppliers placing you on cash-on-delivery (COD) terms (lack of trust)
• issuing of post-dated cheques by management or incurring of dishonoured cheques penalties
• special arrangements, or payment plans with selected creditors
• payments to creditors of ’round sums’ that are not reconcilable to specific invoices (part paying invoices)
• overdraft limit reached, continually being breached or defaults on loan or interest payments
• problems in obtaining finance or poor credit rating for your company
• changing banks, lenders or increased monitoring/involvement by financiers (who may hold security)
• inability to generate funds or interest from shareholders
• failure to pay ATO, lack of tax submissions, overdue taxes and superannuation liabilities
• director and management disputes, multiple director or board resignations, or loss of management personnel
• increased level of complaints or queries raised by customers, creditors and suppliers
• an expectation that the ‘next’ big job/sale/contract will be sufficient to save the company.

Early warning signals do not necessarily mean the organisation is likely to fail. However, the more warning signals are detected, the stronger the evidence of financial duress and likelihood of insolvency. Directors should consider obtaining professional advice if concerned that the company might be experiencing liquidity difficulties.