Managing your cash flow – understanding ‘Insolvency Indicators’ in your business.

Cash flow is key to any business and while cash pays the bills, many business owners are unable to produce a cash flow statement – a statement recording incoming and outgoing cash amounts – to assist them in managing the budget of those bills.

It is important that business owners develop an appropriate cash management process as well as accounting reporting systems that show the cash position. Many businesses that fall into insolvency do not have accounts that assists them in understanding their cash position.

It is also necessary that business owners are aware of the established indicators of distress (referred to as Insolvency Indicators) so that they can know when their business is beginning to fail and that they may take appropriate action to avoid their company becoming insolvent.

Effective Accounting Packages
Many SME businesses purchase accounting based software to run their businesses. They purchase this software as a way of getting cost effective, professional help to understand the financial position of their business under the belief that this understanding is critical to running a profitable and successful business.
While they are right in this belief, what they usually purchase is inadequate software packages. Over my years as an insolvency and business restructuring expert, I have seen hundreds of companies using accounting software packages fail to remain commercial, entering into insolvency. When reviewing the financial performance of an insolvent company, it is clear that the SME has failed in its obligations to maintain adequate books and records. The company usually prepares a balance sheet and profit and loss statement but rarely do we ever see a forecast cashflow statement estimating the amounts of money expected to flow in and out of their business over the next 12 months. Often it is this reason why the company has failed – the decision makers lacked the necessary visibility on their business’s future cash position to avoid insolvency.

Insolvency Indicators
Insolvency indicators are well established principles for business owners. It is key that business owners are aware and understand these indicators and consider them when managing a business. They come from the 2003 ASIC v Plymin (Plymin case) handed down by the court. The judge, amongst other things, outlined a checklist of 14 insolvency indicators, indirectly assisting many business owners by providing them with guidance around what financial indicators they should be focussed on.

1. Continuing losses – identified through the monthly profit & loss reports combined with a comparison against the monthly cash spend (cash burn) A strong business owner will be able to identify (forecast) any potential future cash shortages of a business and take the appropriate action.

2. Current ratios below 1 – calculated by dividing total current assets (cash, inventory and debtors) by current liabilities (trade creditors, statutory creditors and any loans due to be repaid in the next 12 months). If the calculation generates a negative, that is a number below 1, this means that liabilities are greater than assets and the company is considered to be in financial distress. This ratio is a widely accepted figure used by financiers, directors and economic analysts and is considered a very easy and effective way to monitor financial distress.

3. Overdue Commonwealth & State taxes – this is a common problem for companies as many business owners take the view that taxes can be paid later and that it is more important to use all current funds to manage short-term working capital. It is important to understand that the Australian Taxation Office (“ATO”) have taken a more aggressive approach against people who don’t pay their tax. Some examples of ATO actions include the registration of a taxpayer as a ‘delinquent payer” on VEDA – the largest credit reference agency in Australia. This impacts your credit rating with trade suppliers and financiers making it difficult for you to get supplies and money. The ATO have, also been known to take registered mortgages over a business owner’s personal residence. In short, do not ignore the ATO. If you do not pay your tax, they will wind up (finalise) your company, issue garnishee notices, issue Director Penalty Notices (known as DPNs), enter into payment plans with personal guarantees attached to the agreement and undertake other aggressive collection methods. Don’t take the ATO for granted. They have significant greater powers today than in recent years and they are much better at using these powers to collect their debts.

4. Poor relationship with present bank including inability to borrow additional funds – recently banks have been very helpful with business owners that require assistance because of short-term cash flow issues. It is important to regularly communicate with the bank and work with them by keeping them informed on any concerns around lack of cash. While the environment to borrow further funds has become extremely difficult, banks are willing to provide extensions to repaying facilities through entering into special agreements and having an accurate and readily available cash flow statement assists you in being able to notify and work with the bank as early as possible. It also provides the bank with comfort if you have prepared all the types of financial statements (i.e. balance sheet, profit & loss and cash flow statement).

5. No access to alternative finance – it is often the case that business owners can eliminate a short-term cash shortage or working capital constraints by accessing additional funding outside the business. However, as stated above, we are seeing that it is increasingly difficult for businesses to obtain finance from traditional finance sources such as the commercial banks. What we have seen though, is a significant increase in the private funding market with several hundred private funders (private lenders/ finance brokers) now providing financing to business owners as an alternative to traditional bank funding. There are a wide variety of funding options – unsecured cashflow funding, R&D funding, debtor factoring and short-term property backed finance – being some of the examples available to business owners when they are unable to borrow from the major banking institutions, but be prepared to face a higher rate of interest and additional fees. You will also need to adjust your cash flow to reflect the additional costs of this type of financing.

6. Inability to raise further equity capital – if a business owner is unable to source outside capital equity into a business struggling with short-term cash flow then the owner must manage their business closely and be certain the cash burn is not too extreme. In cycles of slow economic activity there are many businesses that fail to see the impending cash crunch coming to their business. The cash flow statement shows a business owner if there has been a decrease in the revenue made by the business as a result of an economic slowdown, increase in competition or outstanding debtors (increase in the number of customers owing you money). There are also issues that can arise when there increased economic activity or a high demand for your industry’s products or services – for example a building boom. During these periods, we often see an unusual hike in salary costs due to the high demand for specifically skilled employees. Whilst revenue and profits might be strong at the time of hiring these “expensive employees”, this cycle is often followed by a “slowdown” that results in less profits for the business. The business owner needs to spot the slowdowns as early as possible, and if necessary, make the relevant business changes (possibly including staff changes) required to manage the tight cash position. The earlier you see the slowdown the less likely it is that you will need to source external funding. When hiring staff in times of strong employee demand, think about a base salary position with a bonus as an upside for the employee which is based on the profitability of your business. Then when the slowdown hits, you can reduce total salaries without the need to make staff possibly redundant.

7. Supplier placing the debtor on Cash on Delivery “COD” terms – whilst COD may be needed at the start of a new business, if you are an established business operation and you are seeing your trade creditors insisting upon COD then this is a reflection that your business may be a credit risk to that supplier. Further, it is also a sign that you may not be monitoring your aged creditors (suppliers you owe money to) effectively. Take steps to closely monitor your aged creditors, by communicating and working with the supplier to seek an extension of payment terms. Pay them a little bit of money now as a sign of “good faith“ and continue to maintain the communication. Usually by the time this kind of action is taken, the business is already in severe distress. Effectively managing your cash flow will identify financial risks of the business much earlier to avoid the need for your trade suppliers to place your business on COD.

8. Creditors unpaid outside trading terms – similar to point 7 above, a business owner must monitor their aged creditors. Take the steps outlined above to reduce the aged creditors. You may be able to successfully manage your creditors outside trading terms if you ensure you communicate with them regularly. Contact them first. Don’t wait for them to contact you. It shows you are thinking of them.

9. Issuing of post-dated cheques – whilst we are now in a world primarily of EFT and post-dated cheques are somewhat a thing of the past, the same issue remains with EFT amounts bouncing. Again, if you are witnessing this in your business, the likelihood is that business is already in severe financial distress.

10. Dishonoured cheques – again this has primarily been replaced by EFT and I refer to my comments in point 9 above.

11. Special arrangements with selected creditors – payment arrangements are a common mechanism used by the ATO (often the main creditor for business owners) to manage their debt with taxpayers. While payment arrangements are common for statutory obligations, the existence of such arrangements with suppliers is usually more likely to be verbal and informal. As mentioned above, an effective communication approach (including written agreements and emails) with your trade creditors can help you achieve extension of payment terms and pay the debt over a longer period whilst you are managing the temporary cash shortage within the business. Your cash flow forecast can then be adjusted to provide you with a view on whether these payment extensions will be enough to manage the business during a short-term cash shortage.

12. Solicitors’ letter, summons(es), judgments or warrants issued against the company – This is another sign that a business owner hasn’t managed their creditors effectively. Refer to my comments in point 11 with regards to communication.

13. Payments to creditors of rounded figures, which are irreconcilable to specific invoices – Rounded payments often indicate that a special repayment arrangement is in place. Refer to my comments in point 11.

14. Inability to produce timely and accurate financial information – throughout this article I have continued to emphasise the need to produce accurate and effective financial reports. Section 286 of Corporations Act makes it a legal requirement of a company to produce adequate financial statements for a business. Whilst the definition of what is considered “adequate’ varies for each business (due mainly to its size, industry and complexity), the commercial fact remains that strong financial accounting allows a business owner greater visibility to manage their cash and take necessary steps a lot earlier in the risk period of a business suffering from a slowdown.
Conclusion – Manage Your Cash

Effective accounting systems provide valuable information needed for decision making. Spend time setting them up and talk to an expert about the best products and systems to use for your business.
Be aware of the Insolvency Indicators. These allow you to better understand your business and identify earlier in a business slow period, any need to reduce expenditure.
Have strong cash management disciplines in your business. These will better help you to weather any bad period and in good times, help you to build the reserves you might need in future tough times. A good strategy is to invest those monies in assets you can easily convert into cash rather than spending excessively on lifestyle items like expensive cars and holidays.

Identify the key stakeholders in your business. They may be your customers, or a key supplier or the financier. Once those key stakeholders are identified, manage those relationships through proactive communication.

About the Author
Simon Cathro is a Partner of Worrells, an industry leading accounting firm specialising in corporate insolvency, personal bankruptcy and forensic investigation. He has over 23 years of insolvency and restructuring experience having worked with businesses in a broad range of industries including construction services and subcontractors, property, financial services, events and hospitality as well as retail. His key skillset lies in his ability to assess financial viability of businesses. This includes analysis of profitability, business liquidity and strength of forecasting.