When insolvency threatens, be open and honest

This article was current at the time of publication.

With costs and interest rates expected to rise further and business and consumer confidence languishing, accountants need to keep a careful eye out for any early signs of stress among their clients.

“Accountants can sometimes get a bit too focused on preparing financial statements and tax returns,” says Partner at Deloitte NZ, Restructuring and Refinancing, Rob Campbell. 

“We need to look beyond that and at the outputs of those financial statements for issues or deterioration, and for opportunities to bring [them] to the attention of the business owner.”

Campbell says the current economic environment is a good time to attend to basics and compare closely the latest set of a business’s financial data with the previous period.

“Look at how the business is performing in terms of profit and loss [P&L]. Identify material changes in revenue, gross margin, overheads, earnings before interest, taxes, depreciation and amortisation [EBITDA] or net profit after tax [NPAT]. 

“What are the individual components of P&L and what’s contributing to the deterioration of trading performance?”

Practitioners should ask themselves what they’d expect to see. For example, if revenue is down, you’d expect debtors to be down.

What are the signs to spot?

A good place to start is looking at cash balances and working capital, and what’s changed between the two periods. Has working capital moved in line with trading performance?

If accounts receivable is climbing, it signals an outflow of working capital.

“Ongoing debtor risk assessment is important,” Campbell continues. “Where balances are starting to grow or age, you need a clear explanation from the customer as to why.

“It’s also about good hygiene around terms of trade. Check there is adequate retention of title provisions backed up by a Personal Property Securities Register registration, which solicitors can assist with. Make sure you have documentation in place with the debtor – evidence to support your invoicing.” 

Where there are signs of ageing, clients might need to conduct credit checks. An increase in inventory also indicates a working capital outflow.

Falling revenue needs careful analysis, taking into account the client’s specific business.

Campbell recommends a thorough review of the business model and cost base.

“Look at the product or service offered and detailed inventory reports to understand why it’s occurred,” he says. 

There may be options to reorientate the business by changing the product or service model or offer. Can they be streamlined to reduce costs?

Where the customer is using sales resources should also be examined, as they could be better deployed. Or are there warranty issues?

Overheads also need careful review, including headcount and appropriate staffing levels. Could the business operate from smaller premises?

Attention to financing

Financing also needs scrutiny. Shopping around for a better interest rate is unlikely to yield major gains because, as Campbell says, banks are relatively similar in terms of the cost of funding. 

As such, he suggests a different form of debt financing. For example, an overdraft, term loan or trade finance facility may be more appropriate.

While owners spend far more time on the business day-to-day than any practitioner can, they can be unrealistic, Campbell maintains.

“It’s our job to bring objectivity and encourage business owners to think laterally,” he says.

“Accountants often have a long-standing relationship with a client. That means we’re sometimes reluctant to speak up but we still have to maintain objectivity and be ready to have those conversations.”

“Approach the conversation objectively. Set out factually where you think the business is at and the risk of it turning into a stressful situation. The earlier, the better.

“Outline and assess the options available to them, even if you think some [may not] be [palatable]. Don’t just push in one direction.”

With that groundwork laid, if a business is still heading in the wrong direction, it might be time to consider other options, Campbell acknowledges.

These include asking whether there’s an opportunity for amalgamation or aligning the business with another to share costs and overheads, or divesting part of the business to repay creditors. Could the business – or part of it – be operated more profitably by someone else?

Practitioners should establish whether additional equity can be raised to restore the balance sheet to good shape. They should also look at debt restructuring [PDF] or refinancing.

“For practitioners, it’s often about having conversations with other advisers such as lawyers and with the bank.

“Bankers very much expect to see their customers’ advisers sitting alongside them. Look at the information requirements of the bank. Bankers get frustrated if accountants and lawyers aren’t seen, or if they’re [ill-informed].”

Checklist for distressed business customers

Identify where and why business performance has deteriorated since the last accounting period.

Check actual performance against what you would expect to see from a business of this type.

Keep on top of overdue debtors and seek explanations.

Ensure the business has “good hygiene” around its terms of trade.

Review the business model and identify opportunities for reorientation.

Examine overheads and look for opportunities to reduce the cost base.

Review financing and check the level of equity and forms of debt financing that are appropriate for the business.

Be objective and prepared for difficult conversations with clients.