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How to identify a company in financial difficulty

 

 

May 2010

 

Here is a note explaining the "decline curve" of a business, giving guidance on how to get the information to assess how serious a business' difficulties are, and providing an overview of what insolvency means and how to react to it.

1. Plotting the course of a company's decline

Formal insolvency almost always comes at the end of a period of declining business performance, financial distress and cash-flow crisis. By the time a distressed company becomes insolvent (or is near to insolvency), it has limited options and so do those who contract with it. The challenge is to spot the signs of decline and react ahead of the game.

 

Phases of decline

There are, typically, three phases to the decline of a company:

Underperformance. A cash-generative company loses profitability because of weaknesses in its business (such as loss of market share to competitors).

Distress. The business cannot fund any activity outside its immediate operations, and has difficulty meeting commitments to lenders and trade creditors.

Crisis. The company suffers a critical shortage of cash, forcing it to use all the cash generated by the business to meet debts as they fall due.

 

Unless the company takes action to address the difficulties it faces, over time:

-The pace of its decline accelerates.

-The options available to the business and those that deal with it narrow, making a successful rescue or restructuring less likely.

 

Not all businesses decline at the same rate. Where business decline sets in because of an external shock to the business (such as the failure of a key supplier that the business cannot replace quickly), the pace of decline can be rapid, leaving little time to react.

 

2. When is a company insolvent?

 

Insolvency as a matter of fact

 

A company is insolvent if either:

-It cannot pay its debts as they fall due for payment (cash flow insolvent).

-The value of its liabilities exceeds the value of its assets (balance sheet insolvent).

 

Without access to a company's accounting data, it can be difficult to judge if a company is insolvent. There are no extrinsic signs that a company's liabilities exceed its assets. Not every late or missed payment indicates an inability to pay debts (it may be, for example, that the company in question is withholding payment to put commercial pressure on its creditor over a dispute between them).

 

Insolvency as a matter of law: "inability to pay debts"

 

The Insolvency Act 1986 (1986 Act) does not define "insolvency", but adopts the concept of "inability to pay debts" (sections 122 and 123, 1986 Act).

"Inability to pay debts" is commonly used in contractual definitions of insolvency.

A company is unable to pay its debts if:

-It is cash flow insolvent.

-It is balance sheet insolvent.

-A creditor has a judgment against the company and has tried to enforce that judgment without success.

-A creditor has served a statutory demand on the company and 21 days have passed without that demand being satisfied to the creditor's satisfaction (unless the company can prove that it is, notwithstanding its failure to satisfy the statutory demand, solvent).

 

A company with assets in excess of its liabilities is still unable to pay its debts if it cannot (or does not) discharge its current obligations.

 

A company is insolvent if it can pay the debts that are due at present, but does not (or will not) have the resources to discharge those debts that will fall due in the future.

 

3. Warning signs of underperformance

 

Being as close as possible to the company is the best way to position yourself to spot the initial signs of decline and to read them accurately.

 

Central to the viability of any business is that those with whom it contracts are confident that it will fulfil its obligations. The initial signs of decline are those that put doubt in the minds of others about the company's ability to meet its contractual obligations over time.

 

Judge a business' performance in the context of the market conditions in which it operates and compare it to the performance of its peers and competitors.

 

Decline in reputation and market perception

Often a failed (or failing) business passes through a phase where its identity or reputation suffers (either because it is directly sullied or because it suffers by comparison with competitors).

Example: the failures of Woolworths PLC and MFI Retail Limited

Both Woolworths and MFI were long established brands that struggled to adapt to a changing marketplace.

MFI suffered by comparison with, for example, Ikea, and lost market share. MFI's tight profit margins left it unable to discount products to boost sales. As sales were hit by a falling housing market, it became unable to meet its obligations to its lenders and entered administration.

Woolworths' identity as a general retailer suffered in competition with stores that had much more tightly defined product bases. It lost market share because consumers did not have a clear idea of what is was "for". Falling sales led to concern about its ability to pay suppliers and that, in turn, caused credit insurers to withdraw cover. Suppliers ceased to trade with the company and it went into administration.

 

Falling gross profit

Gross profit (the value of a company's invoiced goods, excluding VAT, less the base costs of products) is a basic measure of business performance. Compare the gross profitability of the company (a measure of that company's underlying performance) with that of its peers.

A decline in gross profit may suggest that either the company is generating less revenue from its sales than before or that its production costs are rising. Rising production costs may indicate that the company lacks bargaining strength with its suppliers or that the cost of its raw materials is increasing (which may put pressure on the company's business model).

Falling revenue may indicate a falling market share. In that case, the company may need to cut prices to retain market share.

 

Relaunches and rebranding

Ask yourself why the company is carrying out a relaunch or rebranding exercise. Is it simply designed to lift flagging performance or do the new brands or products complement the existing business?

You should have concerns about a process that simply repackages the existing business to the consumer (with any inherent flaws still in place), rather than creates a potential new income stream.

 

New projects

If there are signs that a company's business is underperforming, ask yourself if the company can afford to divert management time and resource away from its day-to-day operations and into new projects.

Consider if the new project will impact on the company's performance after completion. Even when finished and launched, new projects (for example, new IT systems) can have operational problems and can take time to integrate with the existing business.

 

4.Warning signs of financial distress

 

As a company starts to suffer financial distress, its "corporate personality" can change. Management begins to run the business defensively. It may also look for new sources of funding.

 

A fall in staff morale

Staff, especially those at the front line of a business, often get a feel for the decline of a business before the company makes any sort of statement to its customers or employees. Their feeling of unease at the company's performance often leads to stress and a fall in their morale.

Look for signs of disaffection or concern in the company staff that you deal with, particularly arising from the company's attempts to boost revenue or cut costs. For example, has the company decided to cut staff? Has it cancelled or reduced staff benefits?

Staff outside the main management structure can give an insight into changes in management behaviour. For example, staff of a business in financial difficulty often complain that the management has started to communicate with them less than in the past (when performance was stronger).

 

Changes to a company's performance of its contractual obligations

If a company that usually pays promptly, or within credit terms, starts taking longer to pay or exceeds its credit terms, it may indicate a fall in available cash.

Look for lump sum round payments "on account" of outstanding invoices (a potential indication that the company is marshalling its cash).

If the company is your supplier, look for short or missed deliveries or interruptions to service.

 

The company takes a more contentious approach

A company in distress may attempt to avoid slow payment generating creditor pressure by raising disputes about invoices or performance levels.

Similarly, a struggling company may try to shed unprofitable contracts, by alleging breaches by the other side and using those allegations as a means of negotiating an end to contractual relations.

Look to see if the company corresponds in a more formal way than before (for example, via e-mail or letter when in the past it favoured telephone calls). Check the style of written correspondence for signs of professional input. Consider if the company is creating an evidential paper trail ahead of alleging breach of contract.

 

Changing management structures

As cash flow tightens, more senior levels of management become closely involved in the day-to-day finances of the company. Your contacts may have their authority to bind the company reduced or become subject to greater supervision in their activities.

Check who is on the circulation lists of e-mails about finances, to see if more senior management levels are now copied in on such correspondence. Look, too, for unfamiliar names. Companies facing financial difficulty may bring in (either on their own initiative or at the instigation of a lender) new management to assist in reviewing and changing the business practices of the company.

 

Refinancing or new funding

A company in financial difficulty may try to unlock cash flow by taking on additional lines of finance. For example, it may begin to factor its invoices or take on an invoice discounting facility.

Existing lenders may look to exit their relationship with a struggling business, leading to the company refinancing its existing liabilities.

 

5.Warning signs of financial crisis

 

At this stage in the company's decline, it is effectively "managing for cash". Almost the whole focus of the business is to maximise cash receipts to allow it to fund as many of its current liabilities as it can.

 

Erratic payments

The company may find itself only able to pay suppliers as and when it has funds available. It may make partial payments of debts due. It may pay some debts promptly, as invoices land at the same time as it receives cash, while apparently ignoring others altogether.

The company may stop quoting references on payments, making it difficult to allocate a payment to an invoice. This may indicate that the company's accounting function is operating under pressure (as it juggles scarce cash to meet creditor demands). It may also result from a deliberate policy on the company's part: unreferenced payments take longer to process and so it takes longer for creditors to calculate and chase up debts.

 

Departure of employees responsible for the company's finances

The resignation of the finance director can indicate crisis. While he cannot escape the risk of personal liability for wrongful trading by resigning, he may feel that resigning is his only option if, in his opinion, the figures that he presents to the board do not justify the company's continued trade.

The finance staff as a whole may feel that they bear the brunt of the company's difficulties, as they deal with the direct consequences of the company having limited cash. This may lead to departures within the team.

 

Suppliers putting the company "on stop"

A consequence of erratic payments (and payment failure altogether) is that suppliers refuse to continue to supply unless the company pays its debts. This leads to erratic delivery schedules and inconsistent stock levels.

News of a supplier suspending services to a company tends to circulate quickly within the relevant industry. Other suppliers may follow suit, which exacerbates the company's difficulties.

 

Creditors take formal steps

As the company falls behind with its payments, creditors take formal steps to protect their position. Statutory demands and winding-up petitions are threatened or are issued. Landlords distrain over goods for unpaid rents or issue forfeiture notices.

By this stage, the company has little alternative but to go into a formal insolvency process. Its options are effectively limited to a choice of procedure.

 

6.Assessing "soft" information about a company's financial position

 

Many of the early signs of decline do not show in records available to the public. Formal matters of public record come into play further down the decline curve.

 

Keep in touch with the company and its staff

Regular contact with the company's staff is important to gauge the general mood of the company. Gossip is an invaluable source of information about the health of a business. You can often pick up information (for example, the messages that the company's management delivers to its staff about business performance or refinancing) from unsolicited comments that the company's staff made in the course of your usual contact with them.

Look out for news of staff departures and new managers coming in. Site visits can give an insight into stock levels, which may indicate if the company is having difficulty with suppliers or selling product to consumers.

 

Check the press

The press often covers many of the signs that may indicate underperformance or financial distress (such as refinancing deals, job cuts or poor trading results).

Check both national and local news sources and set up an internet news alert to keep track of stories involving the company in question. Also look at industry journal websites and user forums, where the anonymity of posting can lead to the disclosure of information about business performance.

 

Check your own records

Make sure you have tracked the payment profiles of customers, to spot any changes.

Check stock records to spot any signs of erratic delivery.

 

7.Information about a company's financial position available from Companies House

 

Information available at Companies House

A company must file details of any security that it creates over its assets at Companies House within 21 days of granting the security in question.

Companies House records details of the security created by companies on a public register, which sets out, in brief terms:

Who has the benefit of the security.

The date of the creation of the security and the date of its registration.

What assets are charged by the security.

You can get fuller detail about the registered security by obtaining a copy of the form 395 used to register the charges at Companies House.

Companies House maintains a register of all director appointments. You can search this register by individual name (to narrow the search, you can add a director's date of birth and address to the search criteria).

 

What to look for

Recently registered security may indicate fresh funding injected into the company, or a refinancing or rebanking of existing facilities. See if the company released any prior security (which will show as "satisfied" on the mortgage register). If there was no release of security, the new funding may erode the equity in the assets available to satisfy unsecured creditor claims.

Review the mortgage registers of all companies in a corporate group. If all group companies have entered into cross-guarantees and debentures in favour of lenders, this means that each company is potentially liable for the entirety of the group's borrowing. It also means that an event of default on the part of any member of the group could impact upon an otherwise solvent and cash-generative company.

While there is no legal requirement to register a guarantee, where the security granted is a composite guarantee and debenture, the form 395 may mention this in the description of the security. The composite guarantee and debenture structure is so commonplace that, where all group companies have executed security in favour of the same lender, it is probably safe to infer that inter-group guarantees exist.

 

Obtain a list of all the companies of which the directors are officers. Look for newly incorporated companies in which they are involved, as this may be a vehicle for the purchase of the business and assets of the insolvent company.

 

Obtain the company's annual accounts for the last two financial years, to see if you can detect any trends in the business performance.

 

8.How to react to financial difficulties

 

The risk of making things worse

The actions of those who trade with a declining business can compound its difficulties. If a key supplier stops supply, not only does this impact upon the business' ability to trade, but it may also provoke other trading partners to take defensive action.

Be cautious in sharing your thoughts about the financial health of a company with other suppliers and competitors. There is a risk that negative rumours about a company's financial state can cause the company's decline to become a self-fulfilling prophecy.

A decline in the willingness of creditors to support a struggling company is a factor that directors must consider when reviewing if it is appropriate for the company to continue to trade.

 

How the director's risk of personal liability for wrongful trading can drive a company into insolvency

Directors often place a company into an insolvency process to avoid the risk of personal liability for wrongful trading.

The potential liability for wrongful trading arises where a company goes into liquidation. Where a director is liable for wrongful trading, the court has power to order him to contribute personally to the assets of the company available for distribution to creditors.

Liability arises if a director fails to take every step to minimise the loss to creditors from the company's insolvency after the point at which a reasonable director (with the skills, experience and knowledge of the director in question) would have concluded that the company could not avoid insolvent liquidation. (Insolvency, for this purpose, is balance sheet insolvency.)

Wrongful trading is a potent concern for directors because there is very little certainty about when liability arises. In the midst of managing a struggling business, it is difficult to determine when the company has reached the point of no return and hard to ensure that the directors take every step to minimise loss to creditors.

Broadly speaking, putting a company into an insolvency process insulates a director against liability from the start of that process. This creates a motivation for directors to put a company into an insolvency process, when in doubt about whether to continue to trade.

 

Overview of options available to the distressed company

The primary focus of a distressed business is usually on reducing the immediate financial pressure, to create time and space in which to address the flaws in the business model.

This requires a combination of improving the liquidity of the company's assets (to enhance the amount of free cash in the business) and reducing liabilities.

 

Distressed companies often explore:

-Swapping debt for equity.

-Negotiating standstill agreements, to keep liabilities at a fixed level for a period.

-Using invoice discounting or stock finance to improve the liquidity of assets.

-Implementing a company voluntary arrangement (CVA) with creditors.

 

From the perspective of a trading partner

It is critical for a trading partner to seek as much protection as possible against the cash-flow difficulties and potential failure of a distressed company.

 

Consider:

-Renegotiating trading terms to shorten payment terms and strengthen termination provisions.

-Improve, or insert, retention of title provisions and conduct a site visit to ensure compliance with terms relating to the separate storage of stock.

-Explore alternative trading partners and have a transition plan.

-Know what contractual rights you have and what, commercially, gives you the most leverage.

 

 
 
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Andrew James