Insolvency Issues for SMEs

This is the first in a series of articles aimed at informing directors of their duties and options for small to medium enterprises (SME) if faced with insolvency.

The Australian Bureau of Statistics defines SME as any business that employs up to 200 staff. We believe the two main root causes of insolvency issues for SMEs today are: 

•       Cash flow difficulties; and 

•       Poor management.

Other issues SMEs face that cause insolvency include: 

•       Poor access to finance

•       Obtaining finance from short term cash flow lenders, particularly from lenders operating in the increasingly popular fintech space.

•       Implementing big projects that are not properly financed or provisioned for

•       Growing too fast (overtrading) 

•       Working capital issues; and 

•       Combining one of the above causes with a predictable risk event occurring and creative accounting. 

 Insolvency is an important concept for company directors because of the provisions of Section 588G of the Corporations Act. Ultimately, company directors have a duty to consider the interests of creditors when a company approaches insolvency. If a company is insolvent and a director allows the company to incur a new debt, then the director can be personally liable for the new debts incurred. The Corporations Act makes directors responsible for ensuring their company does not trade while insolvent.

As a result of this risk, WCT Advisory recommends directors, in particular those of SMEs, obtain appropriate advice early when companies experience financial difficulties. To assist directors of SMEs, below are a listing of the major insolvency warning signs:

•       Chronic unprofitable trading 

•       Winding up applications and other creditor actions

•       Director Penalty Notices from the ATO 

•       Employees resigning or high staff turnover

•       Being put on stop by suppliers 

•       Deadlock between owners and/or management about the future of the business. 

While these are all signs of a spiral towards insolvency, it is important to note these are symptoms rather than root causes of insolvency.

WCT Advisory managing partner Andrew Weatherly says directors can save their reputation and business if remedial action is taken early. “If a company is terminally insolvent, then it will fail (liquidation followed by deregistration and likely for a SME, director, bankruptcy due to personal guarantees). Taking early action may allow other options to save a business or have it restructured under another structure, which may allow the director’s reputation to be maintained as best as possible.”

Insolvency is usually worked out retrospectively by a liquidator, so what is more useful to directors is to understand the forward indicators of insolvency. There are several indicators that will be looked at adversely by a liquidator and creditors.  In ASIC v Plymin & Ors. Mandie J identified the following indicators of a company’s insolvency:

•       Continuing losses.

•       Overdue Commonwealth and State taxes.

•       Liquidity ratios below 1.

•       Poor relationship with present Bank, including inability to borrow further funds.

•       No access to alternative finance.

•       Inability to raise further equity capital.

•       Suppliers placing the company on COD, or otherwise demanding special payments before resuming supply.

•       Creditors unpaid outside trading terms.

•       Issuing of post-dated cheques.

•       Dishonoured cheques.

•       Special arrangements with selected creditors.

•       Solicitors’ letters, summons[es], judgments or warrants issued against the company.

•       Payments to creditors of rounded sums which are not reconcilable to specific invoices.

•       Inability to produce timely and accurate financial information to display the company’s trading performance and financial position and make reliable forecasts.

 Mr. Weatherley says if directors think the business is heading for insolvency, then they should consider the above list. “Once they start to tick a couple of the above off, they need to consider getting advice.”

Unfortunately, the prime cause of business failure is poor management. Fortunately, however, for those business owners willing to be proactive and seek help with understanding the root cause of a particular challenged, help is literally only a phone call away.

There is no simple way to learn to manage a business because it is an art that is learnt through practice and experience.