The vast majority of companies in New Zealand are small or medium businesses. The people behind these businesses usually commence business with the desire to earn sufficient profit to enable significant returns to its shareholders. The reality is that very few businesses achieve the level of returns that the shareholders desire, with many businesses achieving no returns at all or failing. In this article, we look at some of the early signs that a company is in trouble, and what a prudent director ought to do to best protect the interests of the financial stakeholders.
“Cash is King”, all businesses need money to survive, and cash is needed to pay employees, suppliers, repay the investments and loans into the Company, and taxation obligations. In our experience, many businesses that end up in liquidation or receivership have had cash-flow issues for a significant period of time. Are you or any of your clients, constantly going outside the terms of the overdraft facility? Are they regularly extending payment terms to significant suppliers? Are your debtors slow paying? Are you behind on your IRD obligations? These are all symptoms of companies with cash flow problems. Looking to extend your credit terms with suppliers may buy some time but the key is to ensure focus is not lost from basic credit control: collect your debts and do not extend further supplies if they are not paying.
Very few businesses have a perfectly constant and predictable level of revenue; sales (of goods or services) fluctuate due to a variety of factors. Whilst sales can fluctuate, in the short to medium term, businesses do not typically have the ability to adjust fixed costs proportionally. The effect of this is that decreasing revenues directly reduces profit levels which ultimately will erode cash flow; conversely increasing revenues directly increases profits thus increasing available cash-flow. Where sales have declined, directors and advisors need to make a sober assessment of the root cause of the decline in sales. Consider whether it is simply a seasonal issue? Is it a production issues, such as an agricultural business exposed to a disease? Is your product becoming obsolete? There can be many reasons why revenue decreases, some which can be easily rectified others which cannot.
With profits declining along with sales, cash flow will become tighter. Not only will it become increasingly difficult to pay suppliers, but eventually the company may not be able to pay its employees, which will quickly prevent the business from trading.
Aside from sales decreasing, in the light of heightened global competition, many businesses are faced with lessening gross profit margins. There is not always the ability to increase prices to respond to increases in input costs. The decreasing margins mean that sales need to increase to give the same contribution towards fixed costs, and ultimately profit. Directors must consider whether the product or service they are offering contributes sufficiently (or at all) to the bottom line, and if not, determine what changes can be implemented to improve these margins. Don’t fall so in love with your product that you’re unable to cut it should it no longer be generating a net profit.
Poor record keeping:
A company director ought to be able to accurately determine the financial position of the Company at any time. It ought to be relatively straightforward to identify what creditors need to be paid, and what debtors are due and payable. We regularly see businesses which are unable to do this and when we are appointed, we are advised there are substantial debtors outstanding, however when we seek to collect payment it is apparent that many of the listed debtors are not debtors at all. Some may have already paid or even never received the goods/services in the first place. Similarly with creditors, we regularly receive creditors’ listings with missing creditors, or inaccurate balances for the creditors. This information must be kept up to date, directors have a statutory obligation to keep accounting records, and not doing so makes it impossible to monitor the performance of the Company, and know what steps to take.
What steps must be taken?
Directors owe a duty of care to creditors and shareholders of the Company to recognise these warning signs and act when they arise. Directors are often optimistic, with “the next big contract” pending, and their advisors need to ensure the directors undertaken an objective assessment of the situation. Once the issues are identified, actions must be taken to rectify the situation. Prudent decisions need to be made. Consider, what costs can be reduced? Can you increase sales? Can you better collect your accounts receivable? Can you increase prices? Can you sell the business? Consider if the business can be turned around, or whether liquidation or voluntary administration needs to be considered?
Whilst some of these issues may be temporary, it is incumbent on directors to identify how significant the problem is and to act promptly. Albert Einstein once said “insanity is doing the same thing over and over again and expecting different results” this applies as much to business as to anything else, problems are unlikely to rectify themselves, and steps need to be taken to improve the situation, or at the very least stop things getting worse. The earlier these issues are identified, the more options there are for all involved.