Practical Steps for SMEs

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

In our previous article, we touched on insolvent trading and the protections of safe harbour. The protections afforded by the Safe Harbour Regime, however, are only the tip of the iceberg.  We will now touch on the commercial risks faced by the business itself, which will drive the turnaround plan.

If a business is struggling and potentially insolvent, that is unable to pay its debts when they fall due, there are several risks that directors need to be prepared for. The first issue to consider is whether the insolvency is temporary (i.e. temporary cash flow issue), or whether there is an endemic shortage of working capital.  

If there is an endemic shortage of working capital, the director’s first steps should be:

1. Seek or advance further working capital (debt or equity), if available; 

2. Take steps to improve the quality of real time financial information for decision making; and

3. Talk to professional advisors to develop a game plan. 

As Mr. Weatherley previously advised, if directors think the business is heading beyond a temporary cash flow issue, they should consider the list of insolvency indicators published by ASIC. “Once they start to tick a couple of them off, they need to consider getting advice.”

The first step may be to seek or advance further working capital for the business, however, in the long term, this does not solve the problem if the business has a loss-making business model.  Immediate options are: 

• Receivable’s finance: Many businesses look at unlocking debtors by utilising receivables finance. This has the benefit of providing immediate access to funds instead of waiting to be paid by debtors. If short term cashflow issues exists, this can be an excellent option to provide breathing space. However, it is important not to become over-reliant with other measures needed to address any underlying cash flow issues.

• Friends, fools and family: You can seek working capital (either debt or by granting equity) from those close to you. However, it is unlikely that there will be an alignment of interests and your lenders are unlikely to be able to assess the risks of lending to you. This may put pressure on your relationships in the event of non-payment and permanently damage relationships. 

• Trade suppliers: You can contact your trade suppliers and ask them to extend terms.  This will have the same effect as a bank overdraft extension on your financial position. 

Reliable financial information will help prevent a business from choosing the wrong strategy by giving the directors insight into why the business is not achieving the required rate of return. There are three simple ways to ensure a business has reliable financial information: 

1. Draw up an annual budget and cash flow forecast, and as the year goes on compare the budget cash flow with actual figures; 

2. Ensure you know what your product/service costs to produce and what affect it would have on profits if for example, sales were increased or decreased by 10%; and 

3. Make sure your assets are valued correctly.  

When a business is failing it can be tempting to get ‘creative’ with accounting and this is one symptom of impending business failure. Avoid the temptation to: 

• Delay producing financial statements; 

• Continue paying dividends (i.e. drawings) through incurring debt rather than retained earnings; 

• Cut expenditure on routine maintenance; 

• Start treating extraordinary income as ordinary income and vice versa;

• Change the ownership title of main assets of the business; 

• Value assets at inflated figures; 

• Meet company debts out of your own pocket; and

• Value stock of finished products at the current market selling price rather than at cost. 

These changes often just temporarily mask the problem and if the company fails, can often be unwound or recovered by a liquidator.

When a business hits rocky times the directors need to develop a clear business strategy. If the directors do not have a clear strategy, they may get lost in the details of keeping the business afloat rather than driving towards their end game. If there is a profitable core that is worth saving, there is a choice between keeping the business and attempting to salvage it or selling the business or assets.  

Once immediate steps are taken, assessing the underlying viability of a business is key. There is little point continuing with an unprofitable business.

It is important directors are properly informed of their obligations and act with the company’s interests in mind (as opposed to their own) and seek advice from a firm like WCT Advisory, who are appropriately qualified and experienced in this area.