Signs of Business Stress

13/04/2010 by Michael Jones

1) General

(i)  A Statistical Approach

A review of the Bankruptcy (Personal Insolvency) and Corporate Insolvency statistics reveal some interesting fundamentals about the movement of Insolvency in the Australian economy.  Surprisingly Personal Insolvency seem to be decreasing from a peak in 2009, current figures seem to be stabilising at 2008 levels.  The 2009 peak appears to have been the result of a continued sustained rise since at least 2005 and there is evidence that this pattern of sharp increases has been a feature of the Personal Insolvency statistics since at least 1988.

It is clear from an analysis of the Personal Insolvency statistics that the vast majority of Personal Insolvencies are non business related.  That is, they are largely driven by consumer debt, chiefly credit card defaults.  A survey of the occupation groups of bankrupts does not reveal any particular stand out trades or professions that are effected by Personal Insolvencies.  However, in most cases the stand out reasons stated for failure relates to excessive use of credit cards, unemployment, domestic discord, economic conditions and lack of business ability.

Another reason for the dramatic rise in Personal Bankruptcies from 2005 to 2009, could relate to the fact that the bankruptcy regime seems to be particularly friendly to the debtor and this realisation had become more widely accepted in the community.

The story appears to be somewhat different in relation to Corporate Insolvencies.  The numbers appear to be steadily rising, although not particularly dramatically.  One key factory that drives Corporate Insolvency numbers is the debt collection activity of the Australian Taxation Office.  This activity affects both Court windings up and Voluntary windings up and also the action taken by Banks appointing Receivers.  It particularly affects the number of Voluntary Administrations as directors usually appointed Administrator as soon as the threat from the Taxation Office appears on the horizon.


(ii)  Reasons for Insolvencies

The reasons given in the statistics for Personal Insolvencies are derived from data provided by the bankrupt’s.  That is the data is sourced from the individual’s Statements of Affairs.  By contrast, statistics provided by the ASIC in relation to corporate failures are generally provided by the Liquidators of companies and in particular are sourced from Section 533 Reports required to be lodged with ASIC by all Company Liquidators where a dividend of less than 50¢ in the dollar is paid to unsecured creditors or where any offences are obvious.

These statistics clearly show that the main reason for company failures in the 2010-2011 year is poor strategic management.  It is interesting to note that the adverse state of the economy does not even make the top 4 on the list.  To some this may seem surprising given the current circumstances, but the evidence suggests that this is a consistent trend.  Notwithstanding the foregoing it is still clear that the major reason for company failures is not the economic circumstances, but poor management.

Since publication of this data by the ASIC, the statistics consistently shown the vast majority of companies that fail are very small companies, for example, almost 80% have less than 20 employees.  In excess of 80% have assets of less than $100,000 and approximately 70% fail with a deficiency of less than $500,000.  In the main these companies are family owned companies with only one or two directors and shareholders.

When we look at the statistical breakdown of company failures by industry, the largest industry in Australia affected by corporate failure is construction.  The next identifiable industry is retail sales.  It could be argued that this is no surprise having regard to the size of these industries relative to the Australian economy.  But it is also the area of business most dominated by family owned businesses.


(iii)  The Economy

The reason for the company failures has remained very consistent since inception of these reports with poor management being sighted as the major reason for company failures.  It is interesting to note that the ASIC also quotes poor financial control and bad records a significant factor; however it is arguable that this actually falls neatly within the heading of poor strategic management.

It is extremely interesting to note that so far as Corporate Insolvencies are concerned at least, economic conditions were not at the top of the list.  Poor economic conditions however were sighted as the primary reason for business related personal insolvency.


2) Specific Indicators

There are usually some obvious signs that a business is in difficulties.  Set out below is a short list of the major items that stand out:

(i) Continuing Losses

In a period of low or zero inflation companies usually do not get into financial difficulties if profitable.  If a company or business is continuing to lose money for an excessive period of time, these losses clearly must be funded either by injection of capital or by continued borrowings.  This clearly cannot be sustained indefinitely.  If a company loses money for more than 3 years in a row, this is clearly a sign of alarm, depending on the nature of the business and the overall business plan.

(ii) Low Liquidity Ratios

Where the liquidity ratios are calculated as being less than 1, this is a clear sign of trouble.  Simply put, it means that the company has inadequate cash reserves or liquid assets to meet its immediate liabilities and this will put the company under extreme stress.  It is a clear pointer to insolvent trading and company directors should always be vigilant to ensure that the balance sheet ratios are in positive territory.  In circumstances where any of the liquidity ratios fall below 1, directors should have a clear reasonable rationale for continuing trading or they will risk being sued for insolvent trading if the company ultimately goes into liquidation.

(iii) Outstanding and Overdue Taxes

One of the clear signs of a company facing financial difficulties is increasing debt to the Australian Taxation Office (ATO).  It is obvious that when a company is facing cash flow shortages, the creditors that scream the loudest will be the creditors that are paid first.  Wages are normally paid, otherwise employees will resign and the company will have no staff.  If the rent is left unpaid, the landlord may change the locks.  Other essential services such as telephone and electricity also become a priority.  If the company has no stock to sell because creditors cut off supply, then it has no business.  However, debts due to the ATO particularly GST are of no urgency when the company is facing financial difficulty.  Therefore it is very common when a company fails to see that there are significant outstanding taxes and money is also due for workers compensation and other insurance matters.

(iv) Poor Banking Relationships

When a company is facing financial difficulty, it usually has exhausted all of its available options to obtain finance.  Often the company’s overdraft is bouncing along at the top of its limit and the directors are constantly asking the bank manager for extensions outside of normal terms.  Bank Managers tend to become nervous and ask for additional security and often this occurs at a time when real estate prices have started to fall thus exasperating the crisis and this of course leaves the bank managers to become even more nervous and even in some circumstances hostile.  Bankers then urge their clients to find another bank or alternatively sell assets to reduce the indebtedness.

(v) No access to finance

This follows the previous heading.  Companies facing financial difficulties are unable to find finance because of all of the circumstances leaving them trapped with a banker who really would prefer not to be doing business with them.  It may also be that the company has had some default and this means that the company’s credit rating is further affected, thus preventing the company from obtaining other forms of finance such as lease or commercial hire purchase or debtor financing.

(vi) Suppliers requiring COD

As a company’s aged payables continues to deteriorate, many suppliers place the company on COD terms.  Clearly in normal circumstances this does not occur, and it is a clear sign that the company is in financial difficulties when a number of the company’s key suppliers will no longer supply the company on normal trading account terms.

(vii) Creditor’s aging

This follows from the previous point.  Mathematically one can see over a period of time larger volumes of the aged payables are moving into the zone of being outside normal trading terms.

(viii) Post Dated Cheques

As cash flow becomes critical, cash flow management becomes a somewhat desperate game.  Managers tend to write cheques and hold them in the drawer for release only as cash flow permits.  Creditors of course are constantly harassing the company for payment and so directors will often give creditors cheques dated at some time in the future saying to the creditor “at least I have given you a cheque, bank it next week”.

(ix) Solicitors’ letters

In the worst cases, a review of the company’s legal file will indicate a plethora of adverse correspondence from solicitors acting for creditors seeking payment.  In the worst cases these may include Statement of Claim, default Judgements, Statutory demands or winding up notices.  These are clearly indications that the company is heading for oblivion.

(x) Inadequate Financial Records

This point clearly comes out of the statistics provided by the ASIC as one of the primary reasons for company’s failure, that is, the inadequate maintenance of proper records, or the inadequate use of the information contained therein.  It is impossible for a company to prepare proper budgets, cash flow analysis or profit estimates if it does not have an adequate system of financial reporting.  Of all the things that must be addressed during tough economic times, this is one issue that requires little or no imagination.


(3) Signs Of Bad Of Management

As indicated earlier the ASIC have identified that bad management is the primary reason for company failure.  The following is a list of indicators of bad management:

(i)  No Business Plan

Before any field of human endeavor can be successful it is important that there be a thorough plan of action.  In the case of a business, this is referred to simplies as the business plan.  The vast majority of SMEs do not prepare a business plan and certainly in relation to company’s that have failed, these plans are none existent.

(ii) Inadequate Budgets

The most important thing that flows from an appropriate business plan is the budget.  Budgets are different for different businesses, but it is essential at the very least that there be a profitability budget and a cash flow budget.  Also, a key ingredient in the budgetary process is a clear calculation of a breakeven point so that the managers of the business know what level of sales has to be achieved in order to keep the business sustainable.  Budgets need to be carefully prepared, realistic and constantly reviewed.

(iii) Inappropriate Staffing

Business is comprised of people.  Business requires well trained, enthusiastic and motivated staff that are capable of the task before them.  For most business leaders, sourcing, training, motivating and leading people is the core to the success of the business.  It is often a clear sign of lack of business acumen to see a company unable to recruit and retrain appropriate staff at the appropriate level.  Business leaders lamenting that they can’t get good staff may well be a sign of their own bad management.

(iv) Undercapitalisation

Many businesses commence with insufficient capital to enable the business plan (if prepared) to be properly carried out.  In addition to that it is clear that if the business is undercapitalised it will have less ability to withstand short term adverse conditions and in these circumstances for the business to be successful it will be relying on sheer luck.

(v) Inadequate or ignored financial reporting

A critical ingredient in good management is regular and observed financial reports.  These reports do not have to be complex but have to be appropriate to the nature of the business having regard its size and the business plan.  It is important that the key performance indicators are identified, measured and regularly reported on.  These indicators should be simply and well understood by the persons responsible for the standards.  If KPIs are not met and the fact is either unobserved or ignored, then the business is clearly not sustainable.  On the other hand if KPIs are not met and management becomes immediately aware of this fact and is able to address the issue in a timely manner, crisis can be averted.

(vi) Lack of attention to detail

In my experience many business fail because what I have observed to be the proverbial “stuff up”.   For example management not properly checking the terms of a contract or management not ensuring that the contract is carried out in accordance with the provisions.  Another example is management not communicating with customers adequately as to the services or goods being provided and adequately meeting customers’ expectations of the same.

(vii) Poor Service to Customers

Clearly if businesses do not provide an adequate service to their customers they are fair game for the competition.  In a competitive market customers vote with their feet.  Liquidators receive constant complaints in relation to services and goods provided by companies that have gone into liquidation from customers’ dissatisfaction with these companies.

(viii) Personality Drivers of Management

Good management goes to the personality drivers of the people involved and this leads finally to the “10 Ps of Success”.  We draw evidence from this from the individuals managing companies that have become financially stressed.  We have drawn anecdotal evidence internally from our practice and from the various Insolvency appointments we have handled over many years.  These essential personality drivers appear to be lacking at least in part in most of the cases involving business failure.