Company insolvency: is your business in trouble?

The trading environment is tough right now. UK Government figures show that company insolvencies have been on the rise since 2021: they are already at their highest level since the third quarter of 2009[1].

Judging whether a company is solvent or not can be a subjective decision. But two common tests are a good starting point:

Balance sheet insolvency test

First is the balance sheet insolvency test which asks: are the company’s debts greater than its assets?

Companies can fail this simple test simply because they have high debts for non-trading or exceptional reasons. These could include Bounce Back loans or loans to finance a management buyout.

Cashflow insolvency test

You also need to consider the cashflow insolvency test: can the company pay its liabilities as they fall due?

In some cases, a company may have ample assets that are not cash. However, if assets cannot be sold, or cash cannot be raised quickly enough, the company would still fail this test, as there’s no appropriate form of payment to deal with immediate debts.

If you think the business might be insolvent, you should seek professional advice. And if your adviser thinks the business is insolvent, then you must consult an insolvency practitioner immediately.

If there is a risk of insolvency, directors owe a duty to creditors to minimise their losses. By continuing to do business when the company is insolvent, you could be found to be wrongfully trading.

This carries serious consequences. A court can order a director who has been wrongfully trading to be personally liable for some of the company’s debts and potentially banned from being a director of any company[2].

Your company may pass the two insolvency tests we’ve already mentioned. But it could still be heading for tough times. Watch out for a number of red flags which could suggest danger ahead:

1. Performance

What if your business normally meets its forecasts but has recently started to underperform? It’s crucial you find the root cause for this setback and take steps to fix it as soon as possible. These steps could include pulling out of specific sectors, scaling back certain activities, or reducing costs.

2. Customers

Many businesses are struggling at the moment, and your customers could be among them. The loss of a major customer can be a huge risk factor. So can increases in customer complaints, as this can highlight problems with your underlying products or services.

3. Costs and cash

High inflation and interest rates are making it very hard to budget accurately. Some costs are spiralling out of control, especially in areas such as energy. Fast-rising costs can quickly push a company towards insolvency, especially if profit margins were already thin.

4. Suppliers

Post-pandemic logistics continue to cause supply chain blockages and delays. But there can be other problems with suppliers, such as quality control or pressure for quicker payment. And if you are importing from overseas, remember to build inflation into your projections and allow for foreign exchange fluctuations as well.

5. Financing

Companies on a downward trend are more likely to have financing issues. Do you find you’re speaking to your bank more regularly about needing or extending an overdraft? Or is it unlikely you’ll be able to repay a loan and at risk of breaching covenants?

The starting point is to step back and create a complete picture of the business and all its components. Having the right information can help you make the best decision on what steps to take. We suggest focusing on the following four interlinked areas:

1. Set a clear strategy

Creditors are much more willing to deal with businesses having problems where there is a clear and specific plan for the road ahead. You need to know where you want to take the business and have thought about the challenges ahead – and how to overcome them.

This often gets missed because people jump straight into the numbers. Yes, forecasts are important. But so are your visions and tactics for your company’s future.

2. Draw up robust forecasts

Forecasts need to be both sensible and sensitised. Scenario planning helps to show whether the figures can stand up to potential difficult economic and trading conditions. This gives credibility to financial plans and means they can be relied on to identify funding requirements for at least the year ahead.

3. Integrate the cashflow

A 13-week cashflow is a great visual tool for the business, as this takes into account items falling outside the coming month and non-trade creditors, such as PAYE and VAT.

But a cashflow forecast by itself is not enough. This needs to be integrated with the balance sheet and the profit and loss account to give a true and complete financial picture. For instance, the cash position could be made to look fine at the expense of liabilities building up on the balance sheet: this would make the business insolvent.

4. Monitor KPI reporting

During difficult times the temptation is to run around firefighting and solving day-to-day problems. But this is precisely when it’s vital to step back and focus on the business as a whole.

Monitoring KPIs helps you do just that, by focusing on critical areas that can help you turn the business around and deliver your strategy.

Recognising the signs of insolvency and seeking advice sooner is key. Once a business is up against the wall and has already missed many payments, there is often nowhere else to go to source financing that will help it pull through.

Don’t be that business. If you think the road ahead is going to be bumpy, make sure the board is aware of the situation and they don’t ignore it. Debate the position with your fellow directors. Prepare and use accurate and timely data to support any decision to continue trading and to make decisions on strategy, documenting these decisions fully. Take advice as soon as you can.