I am asked this question a lot.
Unfortunately, it is never a straightforward answer.
A solvency analysis is primarily a cash flow test. However, there are many other factors that need to be taken into consideration including, analysis of the balance sheet, trading profitability, creditor trading terms, status of statutory liabilities and whether the company can raise funds from external sources. This analysis is then overlaid with a long list of insolvency indicia.
My answer to the question will then normally look like this –
In other words, there is always a period in the middle where the company is borderline insolvent. I will refer to this as the “grey zone”. Even after this position is established, there must then be a consideration of whether the issues are short term or endemic.
A director has statutory obligations under the Corporations Act to not trade whilst insolvent. However, the level of analysis to determine insolvency is complex and requires specialist experience to undertake.
Therefore, how is a business owner without the requisite experience expected to make a judgement call about the solvency, or otherwise, of their business when they are up to their neck in daily operating issues?
A great resource has been issued by The Australian Securities and Investments Commission as a guideline for directors on the warning signs of insolvency. The warning signs are as follows:
- Ongoing losses
- Poor cashflow
- Absence of a business plan
- Incomplete financial records or disorganised internal accounting procedures
- Lack of cash-flow forecasts and other budgets
- Increasing debt (liabilities greater than assets)
- Problems selling stock or collecting debts
- Unrecoverable loans to associated parties
- Creditors unpaid outside usual terms
- Solicitors letters, demands, summonses, judgements or warrants issued against your company
- Suppliers placing your company on cash-on-delivery (COD) terms
- Issuing post-dated cheques or dishonouring cheques
- Special arrangements with selected creditors
- Payments to creditors of rounded sums that are not reconcilable to specific invoices
- Overdraft limit reached or defaults on loan or interest payments
- Problems obtaining finance
- Change of bank, lender or increased monitoring/involvement by financier
- Inability to raise funds from shareholders
- Overdue taxes and superannuation liabilities
- Board disputes and director resignations, or loss of management personnel
- Increased level of complaints or queries raised with suppliers
- An expectation that the ‘next’ big job/sale/contract will save the company
This list of 22 warning signs is like a checklist for directors and their advisors.
On a periodic basis, directors and/or their advisors should review their business using the checklist, considering each warning sign that is apparent in their business. More than 5 signs are an indicator that the business could be entering the “grey zone”.
Once in the grey zone, it is appropriate for a director to seek advice from an experienced professional to understand whether the business is insolvent, and if so, whether the problems are short term or endemic. By taking this step, a director is fulfilling their statutory duties under the Corporations Act, and just as importantly, minimising their exposure to personal liability for insolvent trading if the company was to end up in liquidation.
If you think you or your client is in the grey zone or worse, please contact one of our BCR Advisory directors who are experienced in conducting solvency reviews. It is important for this advice to be timely to allow all options for the business to be explored.