When a business hits rocky times, the directors of SMEs need to develop a clear business strategy.
1. What is your end game? Business continuity or business exit?
When a business hits rocky times, the directors of small-to-medium enterprises (SMEs) need to develop a clear business strategy. If the directors do not have a clear strategy they may be 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. It may be necessary to consider the formal appointment of an administrator or liquidator in either situation if the business is insolvent.
2. You cannot develop a strategy without reliable financial information
Reliable financial information will prevent an SME from choosing the wrong strategy and it will give the directors insight into why the business isn’t achieving the required rate of return. There are three simple ways to ensure a business has reliable financial information:
- Draw up an annual budget and cash flow forecast and as the year goes on compare the budget cash flow with actual figures
- Ensure you know what your product/service costs to produce and what effect it would have on profits if, for example, sales were increased or decreased by 10%
- Make sure your assets are valued correctly
3. When a business is failing it can be tempting to get ‘creative’ with accounting and this is one symptom of impending business failure
Beware if you feel tempted to:
- Delay producing financial statements
- Continue paying dividends (i.e. drawings) by relying on debt rather than retained earnings
- Cut expenditure on routine maintenance
- Start treating extraordinary income as ordinary income and vice versa
- Change ownership title to main assets of the business
- Value assets at inflated figures
- Meet company debts out of your own pocket
- Value stock of finished products at the current market selling price rather than at cost
4. Legal meaning of insolvency
A company is insolvent if it is unable to pay all of its debts when they become due and payable. There is no longer an express requirement that your business must be able to pay those debts out of its own funds or assets so if your business is failing it will be able to seek funding from external sources (or a related party for that matter) to be considered ‘solvent’.
5. What causes insolvency: poor management, the big project, overtrading or predictable business risk?
The bad news is that the prime cause of business failure is poor management. Here is what to look out for:
Refusal to seek or take advice
A director who is more interested in dominating the business rather than leading. This kind of director will make decisions with no regard for anyone whatsoever and will not participate (or allow) any discussion or advice to be given.
Directors who only show interest in matters that concern their particular area of expertise or interest and especially those that lack finance experience in management or suitable financial advisors.
Taking on a big project without up-to-date financial information and reasonable forecasts where costs and times are likely to be underestimated and/or revenue may be overestimated is another mistake that leads to failure.
Overtrading is another major cause of failure. Managers in their attempt to expand their business will seek to increase turnover and share of the market without taking into consideration margins and profits. Setting challenging targets for turnover and market share is common (and expected), but it requires equally ambitious profit targets.
If your business is already in precarious circumstances (such as overtrading or taking on the big project), an otherwise predictable business risk may cause your business to fail. These risks will not cause a healthy business to fail. There is no way to prevent normal business risks. It’s only possible to ensure the risk is managed so the business is not vulnerable to failure in this way.
6. The difference between administration, liquidation and receivership
Administration functions as a way to rescue or revive insolvent companies that have some going concern value worth preserving. If a business goes into administration the business will carry on, however, it will be operated by the administrator appointed voluntarily by the directors. During this time, options aside from liquidation will be considered such as recapitalising or selling the business.
Liquidation, on the other hand, is the process by which a business is brought to an end. At this point, the assets of the company will be sold off and the business activities terminated. Liquidation may, as with administration, be entered into voluntarily or involuntarily.
Receivership is where your financier appoints a receiver to take control of the assets and undertakings of your business and collect the loan.
7. Insolvent trading actions by liquidators against directors
A claim may be made by liquidators against a director of a company if debts are incurred by the company (before liquidation) whilst it is insolvent. Informal leniency by creditors will not necessarily affect when the debt is considered to have fallen due. The defences available to directors against insolvent trading claims are that there were reasonable grounds to expect that the company was solvent and would remain solvent. You’ll need to make sure your financials are up-to-date because a Court may presume the company is insolvent if there are inadequate financials.