Insolvent? The signs, the solutions, the shame

Legally speaking, companies thatcan’t pay their bills on time are probably insolvent. It might be an unwritten Kiwi management code or simply cultural idiosyncrasy but many organisations, especially small to medium enterprises (SMEs), struggle to pay their bills on time – in other words within 30-day trading terms. Creditors are all too frequently forced to wait 60, 90 or even 120-plus days for payment.
Using interest-free capital by holding-out on creditors might be commonplace but, it is risky strategy. The practice makes it difficult to differentiate between enterprises flirting with insolvency from those which simply choose not to pay on time. And the fact that high percentage of enterprises fail within five years suggests that significant number of them trade through varying shades of insolvency.
Why then, do so many unprofitable companies choose to struggle from year to year, until their inevitable demise? It may be part of the Kiwi psyche but Mike Ross, associate professor accountancy, law & finance with the Unitec Business School, says there’s great unwillingness to fold business, even when the evidence suggests they should.

Unrealistic expectations
“The biggest problem is when the principals of business know they’re in difficulty, but choose to do nothing. The stance is generally predicated on an unrealistic expectation of future prospects. They might not realise how badly they’re doing because of poor accounting systems. They might have some cash in the bank, but little cash flow,” says Ross.
The more insolvent company becomes, the more likely it is that creditors will move to wind it up. And with banks and other funders locking more and more directors into personal guarantees of company debt, individual bankruptcy usually accompanies company’s liquidation. This constrains their ability to obtain credit, take public office or travel overseas.
In cases of particularly reckless trading, directors who haven’t signed guarantees can still be held personally liable for company debt. Reckless trading provisions in the Companies Act allow creditors to encourage liquidator to take action against directors for breaches of corporate governance. Money retrieved in this manner goes into the company’s coffers for distribution among all creditors.
But if so many companies sail so close to insolvency, why do proportionately few get wound-up through liquidation? In most cases, says Ross, the cost of recovering an outstanding debt through the high court far outweighs the amount outstanding. Not surprisingly, the IRD is responsible for putting most companies into liquidation in New Zealand. But more often than not, deal-making with creditors saves disputes over payment from entering the legal domain.
Creditors usually initiate investigations into company’s commercial viability. The process involves stripping out costs, starting with the ‘boy’s toys’, followed by an honest assessment of the company’s future prospects and whether it’s worth saving. Business principals are rarely supportive of turnaround specialist’s recommendations for change. But in the majority of cases, companies being investigated will avoid legal proceedings only if they abide by the change recommendations made, says Ross.

The rescue
Accountants or insolvency specialists have traditionally been handed the task of turning companies round. However, the job is rapidly becoming the domain of rescue specialists like Auckland-based financial intelligence firm, McCallum Petterson. But what steps are involved in rescuing an ailing enterprise?
Banks or trade creditors usually recruit the rescuers whose primary job is to parachute into the ailing company at the CEO or CFO level and effectively work as an interim manager. The four-stage check-up performed by McCallum Petterson focuses on:
* Management.
* Profitability.
* Cash-flow management.
* The capital structure.
It means analysing the current state of the company. Nine times out of 10 this means unlocking vital information about the company’s real financial position, says partner Alison Sarginson. Cash flow is king but instead of using the accounts as tool for managing the business, many managers and owners see financial reporting as little more than an onerous and annoying annual compliance. Many long-established businesses were not equipped to deal with the tough trading condition that prevailed during the early 1990s, according to Sarginson. “It was something they’d never experienced nor provided for.” Many went on spending sprees, instead of retaining cash reserves, and when cash flows dipped they were in trouble.

Save the business?
What financiers and creditors want to know is whether company should be saved or wound up. The relationship between an organisation’s viability and its financial situation is sometimes difficult to establish. company can have viable business, but it may be swamped with too much debt. “Much of what we need to know can be discovered through SWAT analysis,” says Sarginson. “Ironically, even the most basic questions like: Do you have products attractive to sustainable market and, are you receiving adequate margins – have never been answered.”
If this sounds like Business 101 – it is. But many small business operators, especially trades people, lack management training. At the other extreme, managers migrating to SMEs from large corporates and equipped with grandiose plans, swamp the effectiveness of small business.
“Liquidity issues could often be avoided if principals were honest enough and not too ashamed to put their hands up and admit they need help. We are typically seen as Dr Death, but we have to convince company directors that we’re not there to liquidate them.”
When Sarginson and her team enter these companies, more often than not, they’re dealing with principals who are decidedly stressed, feeling the heat from banks and other major creditors, and dealing with depressing staff morale issues.
“With all these pressures confronting them, there’s lot of value in an independent party looking at their business through fresh set of eyes. It’s also our job to assess what additional resources and skills the business might need and identify the options for moving forward.”

Assessing the options?
Not all businesses are salvageable. If route to restructuring can’t be found then, says Sarginson, it should be admitted and accepted immediately. If business can’t be saved, company principals must attend what she refers to as the “come to Jesus” meeting. Once they’ve accepted business closure, principals are effectively out of the picture.
The liquidator’s next job is to work out how the business should be closed and the assets sold off to repay outstanding debt. liquidator and receiver can be appointed simultaneously but unless appointed by the debenture holder under loan documentation, receiver isn’t usually involved. If it’s concluded that company is viable, then it’s important to stop the bleeding as soon as possible. The next step, says Sarginson, is to work out the profit and loss and cash-flow positions going forward. And, depending on the situation, this means talking with creditors, letting them know what’s happening – and telling them how they’re going to be paid.
“To restore profitability we need to look at every part of the business,” says Sarginson. “That means identifying where the company is now, where it needs to get to, and how it’s going to get there. If earnings aren’t high enough, is that due to not having the right sales people or not having the right stock?”
Practical steps to reduce overheads could mean an early exit from lease, reducing staff-levels or rearranging workflows to better reflect the level of business. “Inadequate information about stock turnover, which affects cash flow, usually indicates that company doesn’t really know who its customers are,” says Sarginson.

Telling signals
How can creditor second-guess when it’s trading at risk? The firs

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