Owning your own business can be exciting, however it’s also filled with the prospect of making challenging decisions every day. Faced with survive-or-perish choices, business owners need to think for the long term and draw on different perspectives to make the right decisions. How to deal with business insolvency is one of the common challenges that face business owners. Here, we look at what it is, what causes it, and its implications.
Understanding business insolvency
Business insolvency has legal consequences, especially for company directors, so it’s important to understand exactly when a business is considered insolvent. Insolvency happens when your business is unable to pay all debts when they become due for payment. While this sounds straightforward, in practice, it can be difficult to know exactly when a company has passed the boundary line between cash flow issues and legal insolvency. Things courts will look at to determine insolvency include continuing losses and no access to alternative finance. If a business is finding it hard to obtain alternative financing because lenders have little confidence in its ability to repay or it’s recording continuing losses, these are major red flags for business insolvency.
Courts might also look at things like a liquidity ratio that’s below one (divide total liquid assets by amount of short term borrowing), overdue tax, and a lack of timely and accurate financial information. The liquidity ratio indicates how well short-term borrowing is covered by easily disposed assets, while overdue tax indicates the company is withholding tax payments to preserve cash flow. Other signs of financial difficulty include poor cash flow and unpaid creditors. From a creditor’s perspective, signs of business insolvency could be late payment of invoices, dishonoured payments, or post-dated cheques.
It’s important to distinguish insolvency from bankruptcy. In Australia, bankruptcy is a legal process for individuals, and it’s a declaration that you’re unable to pay your debts. Insolvency can lead to legal proceedings, including civil penalties, compensation proceedings and criminal charges for directors.
What causes insolvency?
Business insolvency can arise from a wide range of factors. Potential causes includepoor cash flow management, business decision making, and capital management. Some businesses run into financial trouble because of a lack of expertise in commercial operations, leading to a higher risk of failure. Others might encounter insolvency because of a lack of knowledge of business practices, not having adequate resources like capital and time, and/or spending too much on business development in an effort to drive growth.
Failure of customers to pay or being dragged down by a failing business are other possible causes. In addition, businesses can become insolvent due to strong competition, deficient financial management, and reliance on credit. Abrupt changes like essential staff members leaving and failure of clients on following through can rapidly affect your business’s solvency. Several staff members leaving might set off other team departures if the departure of crucial talent affects your company’s competitiveness and profitability. Similarly, reliance on a major client who goes bust and leaves invoices unpaid could quickly lead to insolvency for your company.
Unexpected events like loss of business premises, theft, or vandalism can have a sudden and dramatic impact on your ability to trade. In turn, this affects your cash flow and your business could become insolvent literally overnight. Although in some cases this could be mitigated by insurance, a major loss of physical assets can be disruptive enough to cause insolvency.
The above causes can then lead into loss of capital, loss of revenue and loss of credit, which in turn lead directly to insolvency. Multiple problems can compound, leading to payments outstanding, credit issues, and other serious challenges.
What happens next?
Directors have aduty to prevent their companies from incurring further debt when the company becomes insolvent. If you can quickly restructure, refinance, or secure equity funding and recapitalise your business, you should probably appoint a voluntary administrator or a liquidator.
Voluntary administration sees a voluntary administrator appointed to take full control of the business. She or he will be tasked with finding a way to save the company or its business. If that’s not possible, the voluntary administrator needs to administer the company’s affairs to provide creditors with a return that’s better than if the company had gone straight into liquidation. In the process, the company might return temporarily or permanently to trading through a deed of company arrangement.
Alternatively the company could be liquidated, meaning it will be shut down for good. This involves a liquidator taking control to wind up the company for the benefit of its creditors. A third pathway is receivership, which is usually initiated by a secured creditor who holds security over some or all of the company’s assets. The receiver will collect and sell enough of the company’s charged assets to repay the debt. The company could continue to exist after receivership has ended.
Getting a fresh financial start for your business
Business insolvency can have legal implications for company directors. If you run a business, you need to be aware of how to know if your company is insolvent and the underlying causes. Company directors in particular should be aware of potential next steps so they can act quickly to address business insolvency if it occurs.
Sometimes a fresh financial start requires more extreme action than simply changing up a daily habit – such as entering into voluntary administration, or restructuring your organisation. That’s where we can help. We’re the experts, so contact us on 1300 750 599 to discuss your circumstances.