Identifying the early warning signs of insolvency

Business

Insolvency is the greatest fear for many business owners, especially in an uncertain or volatile economic climate. While Australia’s economy is stronger than it was during the global financial crisis, there is still a real risk of businesses becoming insolvent for any number of reasons.

By Domenic Calabretta, Mackay Goodwin • 12 October 2018 • 10 minute read

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>It’s important for business owners to understand the risk factors for insolvency and act to mitigate the risk before it’s too late.

The biggest issue for businesses is that they ignore or don’t recognise the warning signs, then leave any corrective action until it’s too late. While it’s often possible to turn a business around, the best approach is to avoid hitting that worst-case scenario through early intervention. Business owners should monitor their businesses closely and, if they start to demonstrate any of the warning signs, take corrective action immediately.

These are 10 warning signs that a business could be heading for insolvency:

1. Inadequate cash reserves

Businesses must first look to service their existing and ongoing debts and obligations. However, it’s also important to have reserves in place to deal with unexpected events, fund growth strategies, and leverage opportunities as they arise.

2. Poor cash flow management

Similarly, if the business fails to manage cash flow strategically, then otherwise-unremarkable business events could become catastrophic. This includes things like losing a major customer, paying increased interest rates, or correcting ineffective control systems.

3. Inability to access finance

If a business can’t access finance either because the banks deem it too risky or because the business is at the limit of its borrowing capacity, this can be a significant warning sign.

4. Opaque reporting

Businesses that are at risk of insolvency may have difficult-to-understand or unnecessarily complex financial reports that don’t clearly show where income or losses are coming from.

5. Late payments

Businesses that are in distress often hold back payments, request extensions or emergency funding, or fail to pay invoices altogether. If the business is unable to pay its obligations in full and on time, this should be cause for concern.

6. Staffing issues

If the business is experiencing excessive staff turnover and/or there are any issues with paying staff on time, this is another sign that cash flow either isn’t being managed well or funds simply aren’t available.

7. No clear business model

If the business can’t clearly articulate who its customers are, how it makes money, and where future growth will come from, then it’s unlikely to be well managed. Warning signs include not having an updated organisational chart, no succession planning or formal business planning, and ineffective or absent performance management processes.

8. Over-reliance on key people

Some businesses can thrive by relying on one or two key people but this is also a risky strategy. If the key people are no longer available to the business, it could result in that business becoming unable to operate. It’s therefore advisable to structure the business so it doesn’t rely so heavily on one or two linchpins.

9. Lack of attention to market fluctuations

If business managers aren’t paying careful attention to the landscape they’re operating in, they can miss key opportunities and fail to keep up with the competition. Declining sales should be an early warning sign that something needs to change; if managers aren’t on top of these numbers, the business will be at risk.

10. Reluctance to address issues

If managers are reluctant to identify and address issues around business performance, then it will be difficult to maintain competitiveness. Managers need to address issues as they arise and, if necessary, enlist the help of specialist business advisors.

Insolvency isn’t the only option when a business is in trouble; it’s the last resort. By keeping an eye on these warning signs, business owners can act sooner if the business looks to be in trouble. This can include restructuring the business, employing a business advisor, diversifying, and more.

Identifying the early warning signs of insolvency

Domenic Calabretta, Mackay Goodwin

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