Updated: 11th February 2021
There are various indications that a company is experiencing financial difficulty and could potentially enter insolvency, and an accountant is a crucial figure in spotting these early warning signs.
When action is taken early to avoid insolvency, it provides the opportunity for directors to trade their way out of difficulty, and certainly expands the company’s options for recovery. So what might an accountant look out for in this respect?
Poor cash flow is often the first sign that a company is struggling financially, and usually results in threats of legal action from creditors when bills remain unpaid. Cash flow problems are caused by a number of factors, including ineffective debt collection and credit management procedures, and holding too much stock unnecessarily which reduces the amounts of working capital available.
An accountant will check whether company debtors are taking too long to pay, by looking at the aged debtors report. This shows the value of debts owed over various time periods, and can confirm whether directors need to take action to collect money in more efficiently. Failing to collect debts quickly results in a lack of cash to pay the bills, which can easily lead on to threats of legal action from dissatisfied suppliers and other trade creditors.
When creditors start to threaten legal action against a company, it is a clear indicator that its financial status is declining and that action needs to be taken. This is especially the case if arrears of tax and National Insurance exist. The company should contact HMRC as soon as possible, as otherwise they are likely to take action themselves to quickly recoup the debt.
The accountant will compare the figure for bad debts with the previous financial year, because increasing bad debt levels indicates the current system of collecting debts is not working efficiently.
An increase could indicate that customers have become insolvent themselves, or are experiencing similar cash flow difficulties. The problem is that these debtor balances probably represent a significant part of the working capital available to the company.
If directors are making applications for extra credit from suppliers – often relatively small extensions to their credit limit, but to a number of different suppliers – it indicates an adverse cash flow situation which could eventually lead the company into insolvency.
Obtaining extra credit in this way can provide a temporary ‘fix’ but is not a sustainable way to run the business in the long-term. Additionally, directors need to be careful if the company is close to insolvency, as they may be at risk of wrongful trading.
The bank may return cheques as unpaid once the overdraft limit has been reached. This should alert the accountant to potential problems, especially if the company has used the overdraft limit to its maximum for a significant length of time.
Directors are obliged to be aware of their company’s financial position at all times, and if they do not have access to current figures, may face accusations of wrongful trading should the company become insolvent. This is why it is vital to set up efficient management information systems whereby directors can find out on a daily basis where their company stands with regard to solvency.
Overtrading occurs when a company takes on new orders without having the resources to fulfil them, for example if staff numbers are short, or there has been insufficient investment in equipment to complete an order. Cash flow is often stretched beyond breaking point at these times, and the company begins a decline before they are paid by their customer.
An accountant will notice if there is a sudden increase in staff turnover, which could potentially run alongside a freeze on director salaries/remuneration. Staff dissatisfaction or an awareness that the company is not performing as it should, can lead to employees leaving, and further compromising a poor financial situation.
Begbies Traynor are specialists in business rescue, and can offer the professional guidance you need if your company is experiencing financial distress. Call one of our licensed insolvency practitioners to arrange a same-day consultation free of charge. We have over 70 offices nationwide, and can quickly assess your company’s current financial status.