Cash flow

Six warning signs your company may be on the verge of collapse

Eloise Keating /

Hundreds of Australian businesses collapse each year, owing millions to creditors.

While the likes of pie franchise Pie Face and jewellery chain Bevilles have come out the other side, these examples are in the minority.

According to Cliff Sanderson, chief executive of corporate recovery firm Dissolve, voluntary administration will only save around 10% of companies. It is far more common for the company’s assets to be liquidated.

“Only around 33% of voluntary administrations result in a Deed of Company Arrangement, commonly called a DOCA … [which] is simply a formal deal between a company and its creditors,” Sanderson told SmartCompany.

“Of those companies that find their way to a DOCA, only 28% have some sort of creative outcome, such as saving the business. The rest don’t try and save the business, they just settle matters outside of the liquidation process.”

SMEs are also more likely to collapse than their counterparts at the big end of town. In the 2013-14 financial year 86% of the more than 10,000 companies that collapsed had assets of $100,000 or less, while 81% of insolvencies during the same period involved companies with 20 employees or less.

So what are the warning signs your company may be on the way to the corporate graveyard? SmartCompany asked a panel of experts what to look out for and how to go about getting your company back on track. 

1. The warning signs: revenue drop

Poor financial metrics are the obvious place to start when looking for warnings signs that a company is in trouble.

According to John Swete Kelly, principal of business advisory at Crowe Horwath, companies collapse for a variety of reasons, including lack of profitability, poor cash flow management, “growing broke”, and poor accounting, bookkeeping and recordkeeping.

A sudden drop in revenue, increasing costs that are greater than an increase in revenue, failing to meet obligatory costs such as superannuation payments, delaying tax payments and drastically cutting costs in a bid to break even are all important warning signs, Kelly says.

Being unable to collect debts owed to the business or pay creditors are also cause for concern. As is a business owner or family member not being able to draw wages, or drawing wages below market rates, or personal expenses becoming muddled with business expenses.

Kelly says these signs can often start appearing quickly, sometimes within a period of between two and six months.

“Typically what will happen is there will be a drop in revenue for some reason, such as a downturn in the trading conditions or the market. The business doesn’t break even and has no cash in reserve to pay expenses. The company may already be working in their overdraft and operating regularly in overdraft is not sustainable. After that goes obligatory payments, such as tax and super.”

He says this chain of events can often unstick businesses that don’t have a cash flow forecast or which rely on a single client for their cash flow.

2. The warning signs: shortage of cash flow

The other category of companies that typically run into financial strife are those that “grow broke”.

“Sales may be going up and profit may be up, but the working capital terms are very long or the business is not good at collecting revenue,” Kelly explains.

“The business may be profitable but there is no cash. There is a big difference between profit and cash.”

3. The warning signs: opaque accounts

But Kelly says all these indicators point to a great issue: business owners being able to understand their accounts.

“Anyone in business needs to appreciate that they need to take the time to have in place good administration practices and robust systems to ensure they are getting quality information in a timely and accurate manner,” he says.

“Having quality accounting is a critical aspect. Appoint a bookkeeper and accountant who understands your business and structures the accounts in the way the business owner thinks about the business.”

At the most basic level, Kelly says business owners should have a clear understanding of their profit and loss and the overall state of their balance sheet to avoid financial strife.

“It shows you the engine of the business and the cash flow cycle. Unless you’re monitoring that, you are potentially in strife.”

Assuming a business’s profit and loss ratio and balance sheet is in order; Kelly says there are a number of other metrics that business owners need to understand to avoid financial trouble, such as free cash flow.

“When a business owner looks at their business, they need to understand the two dimensions: the operating side and the funding,” Kelly says.

“Traditional financial accounts for tax return purposes don’t provide separation of these two things and can actually confuse and mislead.”

It is also important for a business owner to understand their breakeven point – that is, how many units of X do they need to sell to cover their fixed and variable costs – as well as the activity and return on capital employed.

“The return on capital employed is the ultimate measure of success in business,” Kelly says.

“If you can achieve a return that is greater than market expectations, you have a wealth creating business at that stage. You can pay all your creditors, all your staff wages, cover all costs and as an owner draw a market-related wage, and actually have a profit greater than investment and the market’s expectations, others will want to invest.”

4. The warnings signs: poor management

The other reason why companies fail is to do with the people in the business, especially those in leadership positions.

Sanderson says most company directors will blame the collapse of their business on financials but that is “looking at the symptoms, not the cause”.

“In the vast majority of cases, the cause is poor management. Directors know when their company is facing difficulties and most commonly the solution they turn to is to work harder or try and get that next big job,” he says.

“The problem is that in many cases a director tries to work harder whilst actively averting their eyes from what’s going on. They will stop reviewing the monthly case forecast and start hoping for the tide to turn.” 

5. The warning signs: slow to respond

Paul Vorbach is executive director of business education firm AcademyGlobal and a partner at consultancy firm Vorbach Partners. He has developed and taught courses in strategic and turnaround management. He agrees with Sanderson that aside from financial metrics, there are often more qualitative reasons why companies go under.

While Vorbach told SmartCompany management actions that cause companies to collapse are “hard to put in an algorithm”, they occur often enough to be real concerns. These actions, or lack thereof, fall into a number of categories.

The first is a failure to take significant action early enough to avoid company failure. Often what happens, says Vorbach, is members of the executive or management team will recognise the need for change, but are not prepared to initiate wide-sweeping changes.

“They talk about death by a thousand cuts or making small incremental cuts, time and time again,” he says.

“The first problem with this is it shows an aversion to making big, usually difficult decisions and that can be an indicator itself.”

“The other outcome of incrementalism is it leads to a fatigue across the organisation. And that fatigue drives out high performers.” 

6. The warning signs: no courage but lots of confidence

Vorbach says company directors or managers can fall into a trap of trying to appear to be fair and equitable to all parts of a company by making small cuts from all departments, but that can be a “terrible thing to do”. Having what he calls “management courage” means being able to make significant changes in one area, while leaving other areas alone or in fact investing in those at the same time as the cuts.

Managers and directors incorrectly attributing the success or failure of a business can also be a sign of worse things to come, says Vorbach.

“This is where they believe everything good that has happened to date is due to my genius or talents but everything bad is to do with the government or another party,” he says.

“It’s externalising negative impacts but internalising all the positives.”

Vorbach says the period before a company collapses will often be marked by a “period of hubris and exaggerated confidence” on behalf of directors or management and this can be associated with expansions or acquisitions that “mask” the true financial state of the company.

On the face of it, he says companies such as Vietnamese food chain MissChu or Pie Face may appear to be growing as they expand internationally, but the growth can be misinterpreted as an indication of a strong business model.

He says other management indicators include the loss of key people in the business or a long-term supplier – “why are they changing now?” – unrealistic expectations about the benefits of new products or IT infrastructure, poor choice in strategic partners, a lack of managerial experience when dealing with adverse market conditions, a deterioration in the company’s culture, and a failure to communicate with key stakeholders about changes in the business.

How to get things back on track

Our panel of experts all agree it is possible to avoid the fate of voluntary administration or liquidation, perhaps even survive it. But the key is acting and acting early.

“This will sound a little obvious, but the most important thing is to do something,” says Sanderson.

“I don’t mean work harder, I mean do something on a strategic level. Step back and figure out what has changed, what has gone wrong and come up with something that actually changes the way the company is operating.”

Sanderson says a company’s chances of surviving serious financial trouble will depend on where they are placed on what he calls the “restructuring spectrum”, with different solutions available for each situation a company faces on the spectrum.

“First up, if your company is ‘underperforming’ is simply means it is not performing at a reasonable standard,” Sanderson says.

“It’s solvent but profit is not where it should be. Underperforming companies need performance improvement solutions, which can include cost-cutting and other operational initiatives possible combined with debt restructuring while those actions are taken.”

The next stage on the spectrum is “financial distress”.

“The company is still solvent but it is teetering,” Sanderson says. “The solutions offered will normally require a particular skill set and so external assistance is usually required. I categorise the solutions available as workout solutions and it will include turnaround management and debt refinancing.”

But the third and most serious stage is insolvency.

“If your company is classified as insolvent you must act immediately and you will almost certainly need outside assistance,” Sanderson says.

“An insolvent company can be restructured. A director can look at formal restructuring with its bank or it may be necessary to look at voluntary administration. It’s also possible that the business is simply unviable, in which case liquidation is the only option.”

NOW READ: Eight easy cash flow tips for your business

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Eloise Keating

Eloise Keating is the editor of SmartCompany. Previously, Eloise was news editor at Books+Publishing, the trade press for the Australian book industry.

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