Corporate insolvency – this is when a business runs out of cash and can’t afford to pay liabilities as and when they fall due. At this point, an insolvency practitioner will intervene to firefight company finances to rescue the business, although in such cases, early intervention is crucial, writes Jon Munnery, a company liquidation and rescue expert at UK Liquidators.
Seeking a guiding hand throughout the early stages of financial distress can prevent the further deterioration of company finances and secure a lifeline in the face of chaos. What hand do insolvency practitioners play when they oversee the financial health of a business and how is corporate insolvency monitored?
Tell-tale signs of insolvency
Company financials provide a window into how a business truly performs after income and expenditure are accounted for, although in reality – numerous uncontrollable factors mitigate the financial position of a business. From economic stability, inflation, and interest rates to consumer demand, spending appetite and financial security, the health of a business is shaped by numerous economic and social influences.
The health of a business can hit highs and lows in a short space of time, which means that if the business falls into decline, stakeholders must keep a watchful and consistent eye on the business to prevent it from failing. There are many routes insolvency practitioners can take to monitor corporate insolvency which include a cash flow test and balance sheet test, in addition to tell-tale signs, such as creditor pressure, payment demands, poor recordkeeping and maximum borrowing.
Cash flow test
The cash flow test for insolvency takes company cash flow sharply into focus which is the lifeblood of a business. Cash flow is used to cover essential costs, such as staff wages, bills, rent and mortgage payments. When there’s positive cash flow, a business can flourish, although when there’s negative cash flow, a business can quickly fall into financial difficulty which will trigger a chain reaction of problems, such as overdue bills and creditor pressure.
Balance sheet test
A balance sheet is a financial statement that captures the financial position of a business, including the value of company assets, and company liabilities, i.e., how much the business owes. If company liabilities outweigh company assets, the business essentially owes more than it can afford, after which assets may be converted to release cash into the business to rebalance the scales.
Creditor pressure
If the business is under pressure from creditors to make a payment, this may signal that the business is in financial difficulty. If the company is short of cash, payments to creditors may be put on the back burner while the business raises enough to cover essential bills, pay staff and keep company operations ticking.
Payment demands
Overdue or missed payments can lead to extreme creditor pressure in the form of payment demands. After gentle prompts and payment reminders, creditors may step up their debt collection tactics and seek formal action to collect the money owed, for example, by issuing a statutory demand. A statutory demand is a written notice that gives the debtor 21 days to pay the debt or negotiate an agreement with the creditor. If a statutory demand is ignored, the creditor can issue a winding up petition against the business.
Poor recordkeeping
If the financial records of the business are inadequate and inconsistent, the financial health of the business can decline without warning. Dated records, reports and forecasts mean that the director will be unable to gauge the true health of the business due to a lack of vital information available that is instrumental for timely and informed decision making.
Maximum borrowing
If the business has reached the borrowing limit and is now unable to access more credit, it could hit a roadblock. To overcome this, businesses may be required to sign a personal guarantee agreement to provide security to lenders and reassure them that the debt will be paid as a priority if the business becomes insolvent.
An insolvency practitioner will track a combination of the above to monitor the health of the business and assess the risk of insolvency. Although insolvency practitioners are commonly associated with repairing a business after its collapse, they are instrumental in the early stages of financial distress to aid recovery.