How to spot financial distress in your small business client

This article was current at the time of publication.

The bumpy post-pandemic ride continues for small businesses and practitioners would do well to take note. With inflationary pressure, a surge in interest rates, supply chain disruptions, labour shortages and the rising cost of living, it’s little wonder that many are experiencing financial distress. 

In broad terms, financial distress occurs when the amount of money flowing into a business or household is less than the amount that needs to flow out. Bills may not be paid on time and repayment of loans or debts may be delayed. In the worst-case scenario, financial distress may lead to insolvency or bankruptcy.

Partner at Hall Chadwick Kathleen Vouris CPA says that because accountants have a close understanding of their client’s businesses, they are “in the box seat” to identify early warning signs of financial distress. 

Vouris, who specialises in insolvency, says there are many signs to look for. 

“The earlier you can recognise financial distress, the sooner you can help your clients work through it,” she says.

Signs of financial distress

Poor cash flow and trading losses are high-level indicators of financial distress, but Vouris says there are also behavioural signs to watch for.

“If your client can’t provide you with the relevant financial information in a timely manner, this is often a red flag,” she says. 

“If they’re scrambling at the end of the quarter to give you everything you need to do their BAS, it suggests that there’s some poor financial management going on, and this is one of the things that can contribute to financial distress.

“Also, if they’re not paying your invoices on time, that’s another sign there’s a problem in the business.”

Executive Director of Queensland-based business turnaround specialist firm Vantage Performance, Kevin Higgins CPA, agrees, saying that accountants need to look beyond the numbers for signs of financial distress. 

“One of the most important questions that I ask my clients is, 'What's keeping you up at night?',” Higgins says. “When you really listen to what they say, you can pick up on early signs of financial distress before you even look at the numbers. 

“They might say that their relationship with their bank is strained, or they might be blaming their bank because they can’t access extra funds. In most cases, the bank is not the root cause of the problem. The root cause is somewhere in the business.”

ATO debt

Overdue payments to creditors and the Australian Taxation Office (ATO) are another key sign to look for. Data from the ATO (PDF) shows that the accrual of tax debt has increased from A$26.5 billion on 30 June 2019 to A$44.8 billion on 30 June 2022.

“The tax office is doing what it can to support businesses but, during Covid, many people were using the tax office to fund their businesses,” Higgins says. 

“Now they’re highly leveraged and wondering how to get back on track. If you ask clients what’s keeping them up at night, if they’re in financial distress they’re likely to say tight cash flow, which has been exacerbated by increased tax debt.”

Back from the brink

Financial metrics can be applied to help pick up on the warning signs of financial distress. The debt-to-assets ratio, for example, measures the percentage of assets being financed by liabilities, while the liquidity ratio measures the ability of a business to meet its short-term debts by using its assets.

“It’s primarily a cash flow test,” Vouris says, adding that a generally accepted ratio is 2:1, with current assets twice the value of current liabilities.

“You have to have enough money to cover the debts, so you need enough liquid assets that are easily converted into cash,” she says.

Financial distress will not always end in liquidation. Higgins says bringing a business back from the brink is often a “game of confidence”.

“We generally say that turnaround requires 25 per cent of financial restructuring, which accountants help with through things like three-way forecasts and cash flow forecasts,” he says. 

“Another 25 per cent is about operational restructuring, which might include honing production and manufacturing.  

“The other 50 per cent of turnaround is about stakeholder management, and that requires a strong plan to garner the confidence of the bank and the ATO and any key stakeholders that may have lost a bit of confidence in the business. This requires a roadmap for the initiatives that will at least stabilise cash flow.”

While obvious strategies include reducing expenses and increasing revenue, Vouris says scenario planning, restructuring debt and maintaining close relationships with banks and other creditors can also help to keep a business afloat.

“There’s only a couple of ways that you can make more money – either at the top end by charging more or improving efficiencies so that it costs you less to make that money. You also need to get rid of some fat, so look closely at the expenses of a business.”

Vouris acknowledges that helping a business to recover from financial distress can involve some tough conversations.

“Encourage your clients to face the facts, because the longer they delay dealing with financial distress, the harder it will be to recover, and it also limits the options available to them to attempt to fix the problem,” she says.

It’s also important that your clients don’t try to avoid their creditors. 

“Communicating with creditors is important because if they don’t, that will just jeopardise their relationship,” Vouris says. “And don’t avoid the ATO, as they may charge penalties and interest.”

“When a business is in trouble, it’s an emotional time for clients, but they can’t afford to put their heads in the sand. The problems won't fix themselves.”

For further information, download CPA Australia’s Options for clients in financial distress (PDF)