The Red Flags of Financial Distress

As a forensic accountant, it is often not difficult to see when a business is in some kind of financial distress. This is usually apparent from reviewing the Financial Reports for the business.

However, it is a much more difficult task to determine the point in time when a business has deteriorated from a position of financial distress to becoming insolvent. The point in time which a business becomes insolvent is critical for company directors as it represents the point from which they become personally liable for the company debts and can also be the subject of interest for litigants and litigators alike.

The most commonly accepted definition of a solvent business is one in which it is able to pay all its debts, as and when they fall due. It follows therefore that an insolvent business is one which is not solvent. It is worth noting that this is a ‘future- orientated’ definition requiring an assessment of the business to pay the existing debts (at a particular point in time) when they fall due at some point in the future.

Traditionally, the starting point in assessing solvency is to review the net assets of the business. Typically, an accountant may review the balance sheet of the business and estimate the market value of all the assets and compare them to the liabilities. Where there are insufficient assets to cover all its liabilities, it is a sign that the business is not in a healthy position. However, even if the business, after a sustained period of time, produces losses which results in balance sheets that reports an excess of liabilities over assets, there is no guarantee that the business is or will become insolvent because such analysis, in isolation, does not take into account the timing of when debts payable.

The issue as to the timing of when debts become due can be clouded by commercial practice. For example, a key/major supplier for a particular business may have a 30 day payment term policy but chooses not to enforce it as demonstrated by the particular business’ payment history with that supplier. Another murky problem is when the business is able to demonstrate that it has the capacity to raise further capital to satisfy existing debts. For example, in a smaller business, a company director may be able to raise finance it his/her name and inject capital into the business even though the business may have no actual ability to raise finance from unrelated parties, eg a bank.

The following represent some ‘red flags’ which typically indicate financial distress and may possibly point to a business trading insolvently:

1. continuing trading losses;
2. liquidity ratios of less than one;
3. overdue taxes;
4. poor relationship with banks and other debt providers;
5. no access to alternative finance;
6. inability to raise further equity capital;
7. suppliers remove credit terms and place business on COD terms;
8. long creditor days;
9. issuing post dated cheques;
10. dishonoured cheques;
11. special arrangements with selected creditors;
12. judgments/warrants/solicitors letters issued;
13. rounded payments to suppliers not reconcilable to actual invoices;
14. failure to keep proper books and records; and
15. long delays in the preparation of financial statements.

The issue of whether a business is insolvent is a question of fact and therefore each case needs to be assessed on its own merits and the use of hard and fast rules cannot be applied.