Many businesses fail because they have failed to identify the warning signs that could have alerted the owners of impending catastrophic problems. Insolvency is a specialist area, and for a variety of reasons business owners may not pick up on the signals, so what are the tell-tale early indicators that should set the alarm bells ringing?

There are two statutory tests of insolvency:

1.) Cash Flow Test

This test of liquidity is the principal case of failure. Business owners should avoid focusing purely on profit and loss as it is not usually lack of profitability that causes businesses to fail, it’s a lack of cash. A statutory demand can be issued by a creditor who is owed a sum exceeding £750, and if the company cannot or is unable to give an undertaking to pay within three weeks, a petition can be issued to wind the company up.

A company failing to actually bank sales it has made will eventually face a liquidity crisis. Business owners need to be fully aware of the importance of accurate cash flow forecasting, and regularly monitor cash flow to act early. If the current account is permanently at the limit, and the payment of supplier invoices is being regularly delayed they must act to improve cash flow. The lack of adequate management systems in place is a clear warning sign.

2.) Balance Sheet Test

The question is “are the business’ liabilities greater than its assets”? How liquid are the assets such as stock and machinery, and would the company have surplus assets available that could be realised, if necessary, to fund trading.

Business owners should be proactive and plan for the ability to reduce costs if and when necessary. For example a company with high fixed and labour costs would be at risk if one client accounts for a high proportion of turnover. They must understand that new business must be profitable and without significant risks and unfavourable terms for payment.

The largest single creditor of many companies is HMRC for PAYE, NIC and VAT. Now that HMRC has recently started to tighten up its “Time to Pay” scheme, the level of insolvencies can be expected to rise. Struggling businesses often prefer to negotiate with suppliers to keep a business running, however, HMRC will apply for a business to be wound up if crown debts are continually left unpaid.

Credit control plays a vital role in both chasing the monies owed and assessing a customer’s likelihood to default. The default of a major customer can be crippling. It certainly is a warning sign if there is an ever aging debtor book, and write off/credit notes are on the increase. Business owners should ensure that they have robust systems in place, which should include due diligence credit checks and swift action to enforce debtor collection. This will require clear policies on deposits and prepayments, retention of title, security, credit insurance and an assessment of the costs/benefits of factoring/invoice discounting.

Business owners should hold regular meetings to address both the current position and have plans in place to react to situations that emerge in the future. Overdrawn director’s loan accounts, and disproportional salaries and expenses should also be addressed at an early stage, and all directors should be aware of their own potential personal liability.

A good business advisor will be aware of the warning signs and bring them to the attention of the owner at an early stage, even when they may not want to hear it. Early action is even more important in a climate where banks appear reluctant to lend.