Avoiding insolvency

Company insolvency is on the rise. Peri Finnigan reveals the warning signs, the fundamentals of business liquidity and cashflow management, and what happens when a company ultimately fails.

There are an increasing number of firms, large and small, that are facing liquidation, receivership or voluntary administration. Consequently, it is important to identify the warning signs of a struggling company.

Many businesses in New Zealand are currently battling with inflation, the ongoing impact of Covid-19 on their business, staff shortages, material shortages, increased overheads, higher interest rates, reduced margins, the challenges of gaining access to finance and liquidity issues.  These underlying pressures can lead to financial problems and to ultimate insolvency.  

Many businesses will rise to the challenge and get through it. Some businesses are no longer viable. Many have closed the doors or are considering it.
Business failure is not simply a question of solvency or insolvency but a question of whether the business is meeting its goals and its exposures are within reasonable limits.  

The early identification of symptoms can lead to treatment and recovery, much like in the medical sense. A sick business has common symptoms. It is important to act quickly and decisively.

The warning signs of a failing company
Loosely run operations, sluggish sales and an over-extended company create vulnerability and can lead to insolvency. The typical warning signs to watch out for are:

• Inadequate management – poor financial and management information, poor production control, poor customer service, poor quality control, lack of management.
   
• Poor financial planning and forecasting.
   
• Poor credit control.
   
• Poor commercial decisions.
   
• Overspending, excessive stocks, high interest costs, unnecessary business expenses.
   
• Cash problems – excessive borrowings, excessive drawings by business owners, poor debtor collections.
   
• Low volumes or falling sales, slow moving stock, pricing/discounting issues, competition, obsolete stock.
   
• Poor costings and purchasing.
   
• Statutory demands – claims under section 289 of the Companies Act (when terms of trade are in default, unpaid creditors can take action including serving statutory demands and winding up proceedings).
   
• Unpaid taxes – IRD instalment plans, formal demands.
   
• Fixed price contracts in times of inflation.

The fundamentals
Liquidity is key to survival and managing through tough times. Companies must meet current obligations, have adequate cashflow and have access to capital.
The recommendations for avoiding insolvency and responding to the warning signs are to:

• Monitor and maximise cashflow – prepare cashflow reports.
   
• Consolidate key functions, invest in good people.
   
• Manage customer credit – offer finance to creditworthy customers or for strategic purposes.
   
• Free up working capital – reduce stocks and manage customer credit.
   
• Optimise the financial structure – reduce debt and secure access to lines of credit and capital.
   
• Reduce costs and increase efficiency.
   
• Customer retention, successful marketing practices.
   
• Review product mix and pricing strategies.
   
• Review unproductive assets/stocks.

When cashflow becomes a problem

• Review. Have discussions with key stakeholders, establish the financial position and understand performance compared to competitors. Consider the company solvency and creditor position. If the business is beyond repair, consider a voluntary liquidation. If the business is viable, consider business recovery strategies and restructuring.
   
• Evaluate the customer database, assessment of costs, processes to improve, integration of IT, outsourcing options, and reduce underperforming stocks/assets/services.
   
• Collate. Agree an action plan with management.
   
• Secure an agreement with suppliers and stakeholders. Consult an insolvency practitioner to consider formalising a company compromise or to gain advice on informal instalment plans or restructuring strategies.
   
• Implement and monitor the plan.

Risks for directors of companies
Directors are granted some latitude with the decision to trade out of a temporary liquidity problem or to advance an insolvency procedure. But taking steps too late and continuing to trade whilst insolvent can lead to personal liability.  

Directors need to respond to the warning signs. If the company has deteriorated beyond a rescue point, advice should be gained to avoid collapse and increasing the exposure to creditors.  

Directors must also take into consideration the underlying duties and risks raised by sections 135 and 136 of the Companies Act 1993:
The director has a duty to ensure the company does not carry on its business in a manner likely to create a “substantial risk of serious loss” to the company’s creditors; and
The director has a duty to ensure the company does not enter into obligations if at that time it is not reasonable to expect it can meet those financial obligations.
Both these sections create considerable risks for the director of a company that is on the brink of insolvency (or over the edge). If directors are in breach of these sections, they are personally liable and lose limited liability protection.

When a company fails what happens?
A failing company usually finds itself facing the following insolvency procedures:

• Receivership – this involves a secured creditor appointing a receiver and manager to take control. The basic duty is to recover what is owed to the secured creditor and those creditors with higher status. A company facing receivership often finds itself later in liquidation.
   
• Liquidation – this involves the death of the company. A liquidator can be appointed by a board on the occurrence of an event specified in the constitution, or by special resolution of shareholders, or by the High Court. The basic duty of a liquidator is to realise the company’s assets or business for the benefit of the creditors. The process can involve closing the business, paying creditors and investigating any potential financial offences.
   
• Voluntary Administration – this is a tool that businesses can use to trade out of debt and difficulty, avoiding the need for liquidation. An administrator is appointed to run the company – the directors are not removed from office but require consent of the administrator to act. The aim of the process is to administer the property and operations of the company in a way that maximises the best return for creditors and shareholders. This is usually accomplished by a deed of company arrangement executed by the creditors and the company.
   
• Company Compromise – Another way to avoid liquidation is by reaching a compromise with creditors. Compromises can yield far better results for both parties and make it possible for companies to continue operating without the stigma of liquidation. This involves an offer to pay creditors, usually over a time payment arrangement, allowing the company to continue to trade.

Businesses fail for many reasons. Managing a business is a delicate balance. A director should be in a position to clearly understand if the business is failing and take remedial action before it fails. 

Peri Finnigan is a licensed insolvency practitioner at McDonald Vague, an insolvency and recovery specialist firm. Go to https://www.mvp.co.nz/