Addressing the Dangers of Technical Insolvency
Addressing the Dangers of Technical Insolvency
This article addresses the facts and issues surrounding technical insolvency and the steps you can take to avoid this leading to liquidation and bankruptcy. We are using the term ‘technical insolvency’ to describe a situation where in theory the company cannot pay its creditors but the situation has not yet reached crisis point. At this stage there are actions that can be taken to save the company and which is the subject of this.
First a frightening statistic, some 70% of Companies that go bankrupt are profitable. This is because, taking account of the reality that “Cash is King” they run out of available funds and are unable to pay their creditors. However it may be that this is a short-term issue and if certain steps are taken the company can survive and prosper.
It is worth noting that a major cause of this problem is what is known as “overtrading”. This occurs in growing businesses that do not have enough working capital (money in the bank or credit lines) to cover the costs incurred in ‘manufacturing’ the products/services ordered by customers. These bills are likely to have to be paid well ahead of when the funds from your customers become available.
This problem can be part of a more general factor which is the relationship between the Company’s creditor and debtor days, which is how fast your client pays you compared with the time you have to pay suppliers. Incidentally this is a problem that SMEs often face when both buying from and selling to larger companies.
In addition to the inability to pay creditors there are two other tests of a company’s solvency, the first looks at the balance sheet to check that the company’s total assets exceed its liabilities. The second is the cash flow test. Has a creditor, very frequently HMRC, gained a Count Court Judgement (CCJ) indicating likely insolvency?
As a limited company, directors’ liabilities are limited by the act of incorporation provided that you acted reasonably, responsibly and within the law. However failure to do this could make directors personally liable for a company’s debt. If your business is going through a financially difficult period it is essential you understand the risks and take care to avoid this happening.
One of these risks is to have committed the civil offence of ‘wrongful trading’. This is deemed to have happened if the company directors have continued to trade when there was no reasonable hope of avoiding insolvent liquidation, they have not minimised the potential loss to creditors and not put the creditors’ interests ahead of their own.
There are two other risk area that should be avoided. The first is the sale of any of the Company’s assets at less than their true value. This is defined as ‘A Transaction at an Undervalue’. Whether these are done with the intention of keeping the company in business or an attempt to prevent them being used to pay creditors, this is not legitimate and the courts can and will reverse these transactions.
The other is defined as ‘Preference’ that is not treating all creditors equally by paying some rather than others. This has an important secondary test which is there must be a ‘desire’ to make that creditor better off. If proven, action can be taken against all parties involved and again the directors can become personally liable
However the focus of this article is to consider what steps can be taken when the situation has not reached an irreversible stage.
Step 1: Recognise the seriousness of the situation and not stick your head in the sand and hope for the best, it won’t happen! If overtrading is the problem then a new big order is the last thing you need!
Step 2: Make sure that all the directors (and shadow directors) are aware of the situation and become actively involved in working on the solution.
Step 3: Hold regular board meeting and record all the steps you are taking.
Step 4: Ensure your management accounts and financial information are accurate and up to date
Step 5: Develop a daily cashflow model and short-term P&L accounts and look to see what changes can be made to improve the situation. These could include:
- Cost cutting all non- essential items
- Directors to either invest more capital or short term loans into the company or at least take a salary sacrifice until the situation is resolved
- Looking to reduce debtor days: Examine how well you are collecting monies owed to you and whether you can be more proactive in being paid within your terms of business. In the longer term you may need to consider whether your competitive strength would enable you to alter these to be more favourable to you.
- Look to agree temporary changes in terms with creditors, including a HMRC Time to Pay Arrangement. These will require you being able to show that you have a viable recovery plan
Step 6: If you have done all of this then you may well be on the path to survival and a brighter future. However if it becomes clear that insolvency is inevitable, then do not delay and seek help immediately as, in this event, time is of the essence.
Finally, since the 6 step programme we have outlined is often well outside the experience of a company’s directors, it may make sense to have a fresh set of eyes, with specialised knowledge of insolvency, help you to find the best solutions.
DISCLAIMER This blog / article is for information and interest only. It is not a substitute for full professional advice, which will take account of the specific and individual circumstances surrounding your matter. Navigate Business Recovery Limited cannot accept any responsibility for any loss arising as a result of any person or organisation acting or refraining from acting on any information.
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