Factors that put solvency at risk
One measurement of a business' success is its ability to maintain its solvency. Solvency is represented by the excess of your assets over your liabilities and to generate positive cash flow. This article will explore more about what solvency is, the factors you should look out for that risk financial health and what to do if you find your business insolvent.
What is solvency?
Solvency is a business' ability to cover its financial obligations "as and when they fall due." Solvency should not only be calculated by whether or not a business can pay its debts but also by how to maintain an excess of assets over liabilities.
A common measure of solvency is the debt-to-equity ratio. If an organisation has more equity than debt, it is considered solvent. However, if the opposite is true and this pattern continues, the business will be insolvent and therefore considered unable to meet its financial obligations.
Another way to determine if you are operating a solvent business is by measuring your cash flow available to pay future debts. If your reserved cash is enough to cover your future debts, then the business will be considered solvent.
The risk of not maintaining solvency is the repercussions that come with insolvency. The context of a business' state of financial health will determine how, under the Corporations Act, the insolvent company can enter into the formal process of correction which ultimately involves distributing its assets to creditors.
Solvency vs. Liquidity
Although the two are closely related and both indicate the business' financial health, solvency and liquidity have a notable difference.
Liquidity refers to the business' ability to pay the short-term debt by way of its capability to quickly convert assets into cash, whereas solvency relates to the capacity to meet a business' long-term commitments.
An effective way to keep track of short- and long-term commitments is through developing a cash budget for your business. By monitoring the cash budget to actual cash flow you can keep track of any liquidity or solvency issues that may arise and deal with them proactively.
What factors can render you insolvent?
Insolvency is the state in which a business cannot repay its debts, and its liabilities greatly outweigh its assets and liquid cash flow. The Australian Financial Security Authority (AFSA) cited the most common reasons businesses become insolvent. The top five reasons include:
- Economic conditions.
- Personal reasons such as poor health.
- Too many withdrawals.
- Lack of business literacy.
- Excessive interest.
Economic conditions like a sudden market crash can be hard to predict but easy to plan for. Like personal finances, the rule of thumb is to have at least six months of liquidity available should something happen.
Personal reasons closely follow economic conditions, and in this category, illness was the primary reason for business insolvency. A business leader falling ill can greatly impact the financial well-being of their company. Lack of a plan for who would take over should something happen to the CEO, as well as insufficient clear documentation of all business-related events, expenses and projects, can leave all employees at a standstill.
Excessive drawings follow personal and economic conditions and can take the form of spending more than you're making on a business credit card or accumulating too many loans. This can be a difficult category to avoid when you're first beginning your business. Sufficient assets can be hard to come by, and getting approved for a loan with reasonable interest rates can be the first hurdle to jump over when you start a business. However, when it comes to avoiding high-interest rates, be sure to shop for the best loan for your business, build a healthy level of credit and apply for a loan where the interest rates best align with your budget.
Finally, financial literacy is something that can, and should, be learnt. Balancing your books is the best way to see in plain sight where your finances lie. Effects of a lack of financial literacy can include anything from making impractical business ventures or poorly managing your finances to entering into a contract that involves obligations you cannot meet.
A financial advisor can help not only set you up for future success but also help you out of insolvency.
Options if you reach insolvency
Even the best planners can find themselves in unmanageable debt. If this is the case or you simply want to know your options if your business is facing insolvency, here are a few ways to approach this situation:
- Bankruptcy: Bankruptcy normally lasts for three years and a day and occurs when you formally declare that you are unable to pay your debts. It can release you from most of your debts, start you off on a clean slate and provide a lot of relief.
- Temporary debt protection (TDP): TDP protects your assets from being claimed before you can pay your debts. TDP gives you 21 days to put your assets in order. The bank can still petition for bankruptcy, but your creditors are not able to seize most of your assets during this time.
- Total debt agreements: Between you and your creditors, you can set forth a legal agreement to pay off your debts to them on a schedule that works with your cash flow. You will need to speak with a registered debt agreement administrator who will send the AFSA a proposal.
- Personal insolvency agreement (PIA): A PIA offers two options to your creditors. You can appoint a trustee to take control of your assets and distribute them or you can offer to pay your debts in instalments or a lump sum.
The AFSA offers a way to compare options and check eligibility if you need to. However, you must keep in mind that each insolvency correction option comes with it a set of consequences. The best way to get out of debt is to develop financial modelling before beginning your business or prior to making a big purchase. Understand your business' net worth ratio by comparing your current liability and net income by the total liquid asset your business has available.
Working with an accountant
At Wilson Porter, we can help prevent insolvency and make a plan for long-term solvency. We also offer business solution advice, reporting and business structuring to set you up for future success. To get your business finances in line, give a Wilson Porter representative a call today and build a balance sheet that you can be proud of.