Dealing with a company which is or likely to be becoming insolvent can be a time of great anxiety and stress for a business owner, but even if you’re hitting some tough times when it comes to paying your bills, it’s not inevitable that it will all end badly.
Here are some ideas for proactive ways you can turn things around and prevent insolvency.
Strategies for Cash Management
If you maintain good control over your cash position, you’ll have a much lower chance of running into trouble paying your bills. Take a strategic approach to cash management with these three cash flow management activities.
Monitor cash flow regularly
Create a cash flow forecast and keep it regularly updated so you can quickly identify any pinch points where you could be struggling to pay your bills. If you know in advance that you may have a period of difficult cash flow coming up, you can make plans to mitigate the issue before it becomes a big problem.
Optimise working capital
Your working capital is the money you have available to do business. Working capital is made up of your cash at the bank, accounts receivable (debtors) and stock less your current liabilities (creditors).
Optimising your working capital means you reduce your stocks and debtors as much as possible, and you negotiate longer payment terms with your suppliers. It all adds up to more cash in your bank account when you need it.
Consider alternative funding sources
When cash is tight, you may need to consider drawing on other methods of funding your business, even borrowing from family and friends. Longer-term options include mortgages and finding new investors to boost cash balances, but it’s wise to discuss options with your accountant and business advisors. Before taking on more debt or increasing the equity in the business, make sure you understand the potential consequences for future performance.
Strategies for Diversification
An alternative strategy to increase cash and mitigate insolvency risks is to diversify your business. You can do this in a few different ways:
Expand product and service offerings
- The obvious way to diversify your business is to add new product ranges or service packages. You could enhance your offerings organically, or if you’re prepared and able to borrow more, you could choose to acquire existing products from another company.
Develop strategic partnerships
- When cashflow issues hit your business, you might feel that the best thing to do is to tighten your belt and downsize to reduce costs. However, a smart strategy could be to leverage new and existing relationships with others working in a similar niche to you. Collaborating can help you to achieve more while sharing costs with one or more other companies to keep costs manageable.
Explore new business models
- Why not consider developing new markets for your existing products or services? This might include expanding into new geographies or finding new clients in different industries.
Diversify revenue streams
- Be careful not to rely too heavily on a small number of customers for a large portion of your revenue. This creates more insolvency risk if you suddenly lose a large contract or your customers reduce their order sizes, perhaps in times of recession or other economically challenging market conditions.
To avoid receiving an insolvency notice, you may need to think laterally and consider new business directions that you haven’t thought about previously.
Strategies for Risk Management
Managing risk is a massive part of being a successful business owner. Your business is at risk from all sorts of potential issues, including security, operational, legal, environmental and, of course, financial. However, you can implement the following risk management strategies to reduce your insolvency risk.
Identify and assess risks
Using your financial statements, identify and assess any insolvency risks in your business. Ask your accountant to help you interrogate your accounting records and review the following information:
Companies can assess their insolvency risk by reviewing their current ratio, debt-to-equity ratio, quick ratio and interest coverage ratio.
The current ratio is current assets/current liabilities, and most industries aim for 1.5 to 2 for this ratio to show a healthy level of liquidity.
The debt-to-equity ratio is current liabilities/owners’ equity – aim for 1 to 1.5 or even 2 if in certain industries such as manufacturing.
The quick ratio is current assets less inventory/current liabilities and is one of the best tests of a company’s liquidity. The ratio should fall in the range of 1 to 10. A quick ratio higher than 10 suggests that your debtors are too high.
Finally, the interest coverage ratio is net profit/interest expenses and shows how many times you can cover your borrowing costs from your net profits. Often, investors like to see that this ratio is above 3.
Cash Flow Analysis
Your cash flow analysis is one of the most important financial statements to update on a regular basis. It enables you to track whether you have sufficient funds to meet upcoming bills. If you have negative cash flow or low cash reserves, you may be at greater risk of insolvency.
Credit Risk Analysis
Your company’s creditworthiness is another way to assess insolvency risk. Credit rating agencies determine your credit risk profile using information from your financial statements, current industry trends, the current economic situation and your credit history to evaluate your overall credit risk. If you have a high credit risk, you may find that borrowing costs are increased with higher interest and set-up fees as well as tighter criteria for accessing credit facilities.
Develop risk mitigation strategies
Aside from the diversification strategies mentioned above, there are other risk mitigation strategies that could be helpful in reducing your chances of going insolvent.
For an early heads up on potential insolvency risk, pay attention to your financial management processes. Regularly produce and review your P&L, balance sheet and cashflow forecasts to ensure you have oversight of any potential future issues. When you fully understand what your financial statements are telling you, you can plan for any cash flow squeezes in advance and avoid running out of funds to keep day-to-day business operational.
Although you can’t get an insurance product that specifically pays out if you become insolvent, ensuring that you have the right cover in place for other business risks is a sensible step. If your business has unforeseen problems such as property or stock damage, legal claims or loss of income, the right insurance policy can reduce your exposure to financial losses.
Maintain good relationships with stakeholders
There are many stakeholders in a business which could affect the business’ liquidity and ability to avoid insolvency. Developing strong relationships with the following groups of people could enable you to negotiate your position if you find yourself struggling to keep up with your bills as they fall due.
Customers – explain that supply may be disrupted or prices may need to rise, either permanently or temporarily while you deal with the current financial situation.
Suppliers – renegotiate longer payment terms and improved prices.
Employees – keep lines of communication open with your staff and explain how they might be able to help during this period of uncertainty.
Investors – Reassure investors that you are implementing all available strategies to mitigate insolvency risk.
Bank – negotiate better payment terms and interest rates to reduce costs or increase your overdraft temporarily.
Prevention is better than cure
Your business health is critical for success. It’s always better to prevent issues from occurring in the first place than looking for a fix once the problem has happened. By actively putting in place risk mitigation measures, you’ll significantly reduce the chances of your business going insolvent. If this area of business contingency planning is unfamiliar to you and you would like to discuss your approach, get in touch on 0448 000 010, message me on LinkedIn or email me at Eddie@eddiesenatore.com.