Financial Statement for Insolvency - PDF by zio66504

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									                                    Indicators of Insolvency

We are living in a fiscal climate where the Reserve Bank has been raising interest rates purposely
to slow the economy, the ripples from the U.S. ‘credit crunch’ have affected the availability of
money even at the higher rate of interest, and the reduction of the world’s share markets have
reduced the value of savings. Businesses now face pressures that can lead to sever cash flow
problems, and for businesses with marginal profitability and little working capital, can lead to
insolvency and failure.


Added to this economic climate is the ASIC that wants to take more actions against directors for
insolvent trading and other offences. Business owners (whether they are sole traders or company
directors) need to be constantly aware of their financial position, and know whether they have
crossed the line into insolvency and whether there is any realistic route back.


Both the Corporations Act (section 95A) and the Bankruptcy Act (section 5) define solvency – and
hence insolvency - as “A person is solvent if, and only if, the person is able to pay all the
person's debts, as and when they become due and payable”. Insolvency is not like pregnancy –
often you do not suddenly become insolvent. It can be a gradual process and at times during this
process there is no definite answer on whether you are or are not.


The question of when a person or company becomes insolvent, and just as importantly when
company directors should have known, is fundamental to many investigations conducted by
insolvency practitioners and prosecutions of directors and others by ASIC. There are a number of
investigation techniques used to prove a date of insolvency, but these investigations are all done
with perfect hindsight. The question of when a director should know or even suspect insolvency is
less factual.


The 14 Indicators


Helpfully Mandie J of the Victorian Supreme Court listed 14 indicators of insolvency in his 2003
judgment in ASIC V Plymin. These are indicators that should alert a business owner or director to
the possibility that they or the company is or is about to become insolvent. These indicators are
used by insolvency practitioners with perfect hindsight against directors defending insolvent
trading claims. They could also be used by astute business people to consider the question of
solvency before it becomes an issue.




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The 14 indicators listed in the Judgment are:


1. Continuing losses.
2. Liquidity ratios below 1.
3. Overdue Commonwealth and State taxes.
4. Poor relationship with present Bank, including inability to borrow further funds.
5. No access to alternative finance.
6. Inability to raise further equity capital.
7. Suppliers placing [company] on COD, or otherwise demanding special payments before
resuming supply.
8. Creditors unpaid outside trading terms.
9. Issuing of post-dated cheques.
10. Dishonored cheques.
11. Special arrangements with selected creditors.
12. Solicitors' letters, summons[es], judgments or warrants issued against the company.
13. Payments to creditors of rounded sums which are not reconcilable to specific invoices.
14. Inability to produce timely and accurate financial information to display the company's trading
performance and financial position, and make reliable forecasts.


How these indicate an inability to pay debts deserves further explanation, but in a way that the
average SME owner can understand them and put them to practical use.


We must start by saying ‘an indicator or two does not an insolvent company make’. They are
indicators and can only be used as a guide. A company displaying one, two or more of these
indicators is not necessarily insolvent, and not all insolvent businesses will display every
indicator. But the more indicators that are present, the more likely that a business is, or is about
to become, insolvent - or put another way, the more the question of insolvency will move from
“probably not” to “probably is”.


Three groups & Nine Indicators


The 14 indicators can be put into three main categories: Financial Statement Indicators (dealing
with the paperwork); Cash Flow Indicators (dealing with the money); and Creditor Relationship
Indicators (dealing with the people). They then can be reduced to nine general indicators under
these headings.


We have rewritten the list as:




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Financial Statement Indicators
    •   Continuing losses and working capital
    •   A lack of timely and accurate financial information


Cash Flow Indicators
    •   An inability to raise equity or loan capital
    •   Issuing post-dated cheques or having cheques dishonored
    •   Payments in rounded sums and for a minimum amount
    •   Overdue Commonwealth and State taxes


Creditor Relationship Indicators
    •   Poor Relationship with Bank
    •   Suppliers demanding COD trading, or payments before supply
    •   Creditors issuing demands or proceedings


                               Financial Statement Indicators

Financial statement indicators relate to the information that is available in the business’s books
and records – or the lack of it. Financial statements should provide sufficient information for
business owners to determine the likelihood of insolvency, but in many instances they are either
not produced or the results are ignored.


Continuing losses and working capital


Making losses is a signpost that should alert business people to the possibility of insolvency. Not
every business that makes a loss, or even a series of losses, is in danger of becoming insolvent.
As long as working capital resources are available to absorb the losses, insolvency can be
avoided or at least delayed.


Insolvency is brought about by a combination of losses and insufficient working capital. If losses
are continually incurred, working capital will eventually be depleted. Business owners have to
consider the available levels of working capital, and the extent and timing to which working capital
might be depleted and they need financial statements to do so. Many small businesses do not
have much working capital and even a short run of losses will deplete any resources and
eliminate any capability of continue trading.


Working capital is the surplus of current assets over current liabilities (usually measured by a
liquidity ratio), but cash flow and whether the business has the ability to pay its debts is the final



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arbiter of insolvency. Working capital must be able to be turned into cash to meet debts, so a
liquidity ratio greater than 1 may not prove solvency. Business owners need to reconcile losses
to working capital to determine whether it reduces below a critical level, and know whether there
are sufficient liquid assets to pay debts.


A lack of timely and accurate financial information


This is arguably the weakest of the indicators when viewed objectively, but subjectively it provides
an indicator of the likelihood of insolvency. We can conceive of a solvent business that is unable
to prepare accounts in the short term for a variety of reasons. But sound, solvent businesses of
any size will be able to produce accurate financial statements in the long term.


From a subjective view point, experience shows that insolvency and having financial records in
disarray often go hand in hand. Not only do insolvent entities almost always display inadequate
accounting records and a complete lack of reasonable forecasts, they also frequently
demonstrate a reluctance to prepare reliable and timely accounts. People do not want to get bad
news.


Many business owners do not prepare regular management reports and even then pay little
attention to the information produced. Many SME owners use external accountants for little more
than preparing ATO and ASIC returns and as a registered office, and see financial statements as
not much more than an attachment to income tax returns. Very few owners of insolvent SMEs
can lay their hands on anything more than last year’s – or the year before - tax returns and a copy
of the MYOB back up.


Without regular financial information business owners will not know the financial position of the
business. They will not know the extent of losses and the levels of remaining working capital.
They will not be able to convince bankers or other creditors that there is a solution to any cash
shortage they may face – compounding problems highlighted in other indicators.


Without adequate and understandable information, business owners will simply not know whether
the business is solvent or not, and this is something they need to know.


Continued next issue ..




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                                           Part Two

In the last issue we started looking at indicators of insolvency that were originally listed in the
2003 judgment of ASIC V Plymin. We grouped the 14 indicators listed in the judgment into three
categories:
    •   Financial Statement Indicators – looking at indicators dealing with the books and records
        of the business;
    •   Cash Flow Indicators – looking at the typical problems dealing flows of money and the
        inability to actually pay debts when they are due; and
    •   Creditor Relationship Indicators – looking at relationships between the people involved in
        and with the business.


Financial Statement Indicators (Continuing losses and working capital and A lack of timely and
accurate financial information) were covered in the last issue.


                                     Cash Flow Indicators


Insolvency is an inability to pay debts when they are due, so factors that indicate the availability of
cash to do so, or the lack of it, become important. Insolvency must be distinguished from a short-
term cash flow problem, so these indicators look at factors affecting cash flow, as well as the
availability of cash at any one moment in time.


An inability to raise equity or loan capital


As insolvency is a cash issue, businesses with insufficient cash to meet their due debts will have
to raise the extra money to stay solvent. They have three main options.


1. The debtor can refinance by borrowing money on a long term basis effectively converting short
term (due and payable) debt to longer term debt (repayable at some date in the future). If a debt
is no longer due and payable it does not form part of any strict solvency calculation. Obviously
when paying short term debt with long term borrowings care must be taken not to mislead the
new lender about the borrower’s financial position, even if the loan is to satisfy current debt and
alleviate current cash flow problems. Obtaining the new loan may have consequences to the
business owner or director if the entity eventually fails.




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2. The debtor can raise funds from equity capital (issuing shares) to pay due debt. Equity capital
is not debt, and while seeking an eventual return from profits, it does not compete with debt for
repayment and may be a more appropriate and safer method of obtaining funds. On the other
hand, potential equity investors, knowing that an eventual return may be delayed or uncertain, are
likely to be diligent in reviewing the finances and prospects of the business to be satisfied that the
return is commensurate with the risk. Business owners will need to be able to prove solvency and
future profits.


3. The debtor may enter into formal repayment agreements with its creditors. Even though this is
an admission that the business cannot meet its debts in full (that it is technically insolvent), it may
only be caused by a cash flow problem that can be resolved in the short term. Can a debtor cure
its insolvency by negotiating extended payment terms with creditors? In our view the answer is
yes, provided that the further time for payment arises out of a clear agreement by the creditor to
provide extended terms. This is very similar to obtaining long term debt to satisfy due debt.


Not being able to convert sufficient short term debt to long term debt, replace due and payable
debt with equity or negotiate repayment agreements must indicate insolvency to a cash-short
business. It indicates that the problem is not simply short term cash flows, especially when it is
compounded with ongoing losses and reducing working capital.


Issuing post-dated cheques or having cheques dishonored


Issuing a post-dated cheque is one of the classic signs of insolvency. It is also a major sign of
hope - by the debtor and the creditor - that the money will be there when the cheque finally is
presented at the bank. Understandably creditors take the receipt of a post dated as a hopeful sign
that their debt will eventually be paid. But issuing a post dated cheque is an admission that there
are currently insufficient funds to pay all due debts.


Solvent businesses very rarely, if ever, issue post dated cheques as it raises suspicions of
insolvency. A business that infrequently resorts to post dated cheques is more likely to be
suffering a short term cash flow problem – but they should know what is causing that problem and
how and when it will be resolved. Any business with a long history of issuing post dated cheques
is almost certainly insolvent.


A post-dated cheque being dishonored sends a clear message that the problem is more than a
cash flow difficulty. It should tell business owners that (i) their cash flow is at best inadequate, (ii)
their bank has limited faith in them covering the amount in the future, (iii) they could not arrange
payment of the account even when given a second chance, and (iv) without a good explanation,
that they are almost certainly insolvent.


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Occasionally a cheque may be dishonored through inadvertence or through no fault of the debtor,
so one cheque or a series of cheques being dishonored at the same time can not necessarily be
taken as clear evidence of insolvency.


But when the bank repeatedly dishonors cheques it may confidently be assumed that the debtor
is insolvent, as having insufficient funds to cover cheques issued to creditors must equate to an
inability to meet all debts when they fall due - the definition of insolvency.


Payments in rounded sums and for the minimum amount


Sometimes debtors cannot or do not make repayment agreements with their creditors, and
resorts to making a small payment to the creditor and these are usually in a round amount.


The debtor hopes that the small payment will delay the creditor taking any collection action and
will continue supply. They hope that they can resolve the situation in the near future or that the
creditor will be satisfied with a series of small payments. Payments made in this manner cannot
be taken as an agreement by the creditor to extend the terms of the debt and does not have the
same effect as a formal agreement.


It may be inferred that the small payment is being made in that fashion because the debtor
cannot pay all of its debts as they fall due. The debtor hopes to obtain quasi extended credit
terms by default, which is really just an attempt to buy some breathing space and continued
supply.


This is one of the strongest indicators of insolvency, and technically there can be little doubt given
the definition of insolvency. If the part payment does not satisfy the creditor, business owners will
also find some of the Relationship indicators arising.


It is also not unusual to find that cheques are drawn when due – whether in round amounts or not
and whether post-dated or not - but then sit in a drawer for many weeks and are released only
when the creditor demands payment and funds are available to meet the cheque. Businesses
that use this process to pay accounts rarely end up satisfying all creditors, no matter how long
they hold the cheques. They are almost always insolvent.


Business owners that are constantly attempting to piece together informal payment plans must
seriously consider the question of insolvency.


Overdue Commonwealth and State taxes




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Many cash strapped or unprofitable businesses regard withholding the payment of tax
commitments as the easiest way of generating essential cash flow. They reason that there are no
application forms to complete, no valuations to obtain, no bank fees to pay, and no cut off of
supply or repossession to worry about. If interest has to be paid, that interest or penalty may not
be applied for some time and might even be negotiable. Simply, taxes and related debts are
considered the easiest debts not to pay when sufficient cash flow is not available.


So is non-payment of tax commitments (whether GST or PAYG) a good indicator of insolvency?
The broad answer is, yes. Leaving aside those who may simply have an extreme aversion to
paying tax or where there is a real dispute, most businesses will normally meet their obligations to
the tax office when they are due.


It may be assumed that any unpaid amount due to the tax office was not paid because the
business did not have the capacity to make the payment and business owners should look at
whether this position is likely to change in the near future, or the business is insolvent.


                             Creditor Relationship Indicators
Regardless of the business structure, a lot of business is done by people dealing with people and
the relationship between the parties will dictate how business is conducted. Strained relationships
often lead to or come from a strained business. Business owners can get an indication of the
health of their business from the health of their relationships with the people they do business
with.


Poor relationship with Bank


Banks have a distinct advantage over other creditors. The bank knows what funds are on hand
and can assess and analyze the flow of funds through the account. Business owners will have
had to provide financial information to borrow money, and the bank can demand further
information at any time. None of this information is usually available to ordinary suppliers.


A poor relationship with a bank usually stems from:


    •   not paying monies due to the bank;
    •   placing of the bank in a position where it regularly dishonors payments; or
    •   providing financial information which is wrong, misleading or fanciful.


A poor relationship might simply result from the bank’s assessment that the business is not well
managed or financially weak.




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A poor relationship with a bank does not prove insolvency, just as a good relationship does not
prove solvency. The bank may be amongst the last to know of a customer's insolvency because
the customer has operated within agreed limits with the bank while "borrowing" heavily from trade
suppliers and the tax department.


Certainly if a bank has seen a customer’s financial information and refuses to advance further
funds or calls up a loan or overdraft, the reasons for that action need to be established. Banks
very rarely act without proper cause and, although a poor relationship with a bank may be the
result of other factors, it usually is the result of the bank's lack of confidence in the business, and
particularly its solvency.


The bank is generally a business’s main source of funding, and if that avenue has closed a cash
poor business will immediately have to consider its solvency.


Suppliers demanding COD trading, or payments before supply


Individual creditors are the first to know that their invoices are not being paid. An efficient credit
manager or business operator will have systems in place to identify overdue accounts and prompt
remedial action.


Remedial action may involve only supplying goods or services to the debtor on a COD basis.
Placing a customer on COD says that the supplier has no faith in the customer’s ability to meet
future commitments. Some creditors go further and only re-supply when they receive part
payment of the old debt as well as payment for the new supply. They are effectively saying that
they do not believe that they will be paid the old debt in the near future.


In instances where a range of suppliers are overdue and some of the suppliers have limited
supply to a COD basis there are either cash flow problems or the debtor is insolvent. Business
owners have to determine whether there is a realistic short term end to the problem and whether
creditors can be brought up to date. Many do not give this much thought.


An enterprise that has a range of creditors with accounts outside of agreed terms must be
considered at a high risk of being insolvent, and that conclusion is usually justified.


Creditors issuing demand or proceedings


A single letter of demand from a creditor is not proof of insolvency as there may be a real dispute
between the parties that allows the debt to remain unpaid until resolved. Cash flow may also be




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delayed for a legitimate reason and payment may have been delayed longer than the creditor
thought reasonable.


By the time the creditor has instructed a solicitor to write a letter of demand, the business owner
will have to determine whether that legitimate reason is really legitimate or not.


A series of demands from a number of solicitors should create a strong presumption of
insolvency. It would be an unusual business that has a large number of disputes with a number of
suppliers all at the same time, particularly if these disputes are not satisfied in the short term.


Clearly if the creditor moves beyond the demand stage and obtains a judgment the presumption
of insolvency is all but confirmed unless the judgment debt can be paid immediately. When
execution of the judgment by way of a warrant is undertaken by the creditor or a statutory
demand expires insolvency is certain.


Conclusion


How long can a cash flow problem last before it becomes a case of insolvency. A shortage of
funds can only be described as ‘short-term’ if it is certain that problem will be overcome in the
short term.


Placing a time period on overcoming the problem is difficult as some cash flow problems may be
seasonal or caused by specific contractual problems. We are unaware of any judicial
pronouncements on the topic. However, as a general rule, we would expect that short-term cash
flow problems should be solved with all creditors being brought up to date within a period of three
to four months.


If business owners cannot form a realistic plan to achieve that goal, they have to start planning for
the likelihood that the business is insolvent.


Michael Peldan and Michael Griffin are partners at Worrells Solvency and Forensic Accountants,
and are both Official Liquidators and Registered Trustees. Michael Peldan can be contacted on
07 3225 4370 or michael.peldan@worrells.net.au. Michael Griffin can be contacted on 07 3225
4360 or michael.griffin@worrells.net.au.




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