Insolvency – Recognising the Warning Signs

Insolvency – Recognising the Warning Signs

As accountants, there are a number of financial warning signs you would see your clients experiencing that need further attention.  There are also a number of non-financial signs which may be less apparent but are equally as important.  Accountants are at the forefront of being able to identify financial warning signs of distressed companies and are in a good position to assist clients obtaining professional advice and mitigating their risks before it’s too late.

The warning signs can be singular but ordinarily it is an accumulation of these factors impacting clients that indicate they are at risk of becoming insolvent, if not already.

Here is a handy checklist for you to refer to.

Warning Signs within Financial Statements

Accruing losses – A company accumulating losses over various periods can be an indication of an insolvent company.  Also concerning is a company that is recording small profits but these profits are insufficient to satisfy the company’s accruing unpaid liabilities, such as Commonwealth taxes. Whilst these are signs of insolvency it is necessary this is assessed in conjunction with the company’s liquidity and ability to raise alternative financing from other sources.

Liquidity Ratio (Deficiency of Assets compared to Debts) – A company’s net asset position is a measure of the company’s ability to satisfy its liabilities from its assets. A negative net asset position and a liquidity ratio below 1 signifies the company does not have sufficient assets to meet its debt obligations. Negative net assets and/or a liquidity ratio below 1 on its own is not a definitive indicator of insolvency and should be considered in conjunction with the profitability of the company.

Poor Cash Flow Management – A company must ensure it can service existing and ongoing debt obligations but it is also important to have reserves in place to deal with unexpected events as they arise.   If a company fails to manage cash flow strategically, then unexpected events could become catastrophic. When facing cashflow difficulties, directors very often either try to increase their overdraft facilities, introduce personal monies either from their own resources or family and friends or utilise cash reserved for taxation and superannuation liabilities. While this may alleviate current cashflow difficulties, it doesn’t necessarily address the cause of the company’s cashflow issues and results in an increase in company liabilities.

Overdue Commonwealth and State Taxes & Lodgements – A history of overdue lodgements and increasing debts owed for Commonwealth and state taxes is a common indicator of insolvency e.g. GST, PAYG and payroll tax.  Further, the ATO has the ability to recover unpaid PAYG liabilities from directors under the Director Penalty Notice (DPN) regime and from 28 October 2019 the ATO can report tax debts greater than $100,000 to registered credit reporting agencies, under certain circumstances, as discussed in the ‘Disclosure of Business Tax Debts Under New Reporting Laws’ article.

Overdue Superannuation – From April 2019 the ATO’s powers increased with respect to the recovery of superannuation debts from directors under the DPN regime with unpaid superannuation now required to be reported by the due date (within 28 days of the quarter end) rather than the previous 3 months from due date to avoid automatic personal liability by the Director .  It is critical if a company is unable to pay its super obligations that they lodge a Superannuation Guarantee Charge Statement with the ATO by the due date for payment of superannuation. Failure to do so will leave the directors automatically personally liable for that superannuation.

Creditor Payment Terms – There are a number of warning signs that can be identified from a company’s relationship with creditors.  These include an increase in the number and quantum of aged creditors, paying creditors outside credit terms, entering into special arrangements or repayment plans with creditors and payments of round amounts that are not reconcilable to invoices.  A company that is regularly entering into repayment arrangements or paying rounded sums on a recurring basis has a high chance of being insolvent as the company appears unable to make payment of its debts as and when they are due.

 

Other Warning Signs (i.e. not necessarily identifiable from the financials)

Access to Finance – Another warning sign is if a company is unable to access mainstream finance, is at the limit of its borrowing capacity or is unable to access further funding from related parties or shareholders. In addition, when a company has reached its borrowing limits it is common to see directors using personal credit cards to pay company debts. On its own these are not a sign of insolvency but in combination with the other factors it provides an indication that the company may be insolvent.

Legal Action – Legal or court action taken against a business for the recovery of outstanding accounts or a significant claim lodged against the company is often a trigger point for distress. An action may result in significant time and resources being utilised to defend the company’s position and may result in an adverse outcome which can cause stress on the company’s cash flow. An adverse action could result in a winding up application being issued which may indicate that the business is insolvent.

If your client is exhibiting a combination of these early warning signs and is experiencing financial difficulties it may be insolvent or at risk of becoming insolvent and corrective action should be taken immediately.  Clients that hold licences to conduct their business (e.g. QBCC, real estate licence or security providers) are subject to additional regulations and risk cancellation of their licence if the company is insolvent. Given this additional risk, it is important for these clients in particular to obtain proper advice immediately if facing financial difficulty.

This is not a comprehensive list of warning signs but it is important to be aware of these signs to recognise when your client is experiencing financial difficulty and obtain professional advice.

Article written by Christine Stead, Senior Manager, SV Partners Gold Coast