More businesses are drifting closer to being labelled insolvent, but are nowhere near complete failures – yet. MIKE PRESTON reveals the warning signs and maps a way out of the mire.
By Mike Preston
More businesses are drifting closer to being labelled insolvent, but are nowhere near complete failures – yet. We reveal the warning signs and maps a way out of the mire.
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Insolvency. It is a word that sends shivers down the spines of entrepreneurs, evoking the twin nightmares of business failure and legal risks for directors and owners alike.
And it is a growing threat. According to the latest Australian Securities and Investments Commission data, administrators were appointed to 780 companies in May, the highest number since monthly statistics started being published in 1999.
The gloomy economic outlook suggests the number of insolvent companies entering administration for 2007-08 could approach the 8000 mark – another record.
Insolvency and turnaround practitioners tell a similar story, with some reporting a significant surge in inquiries and work over the past few months.
In this environment, the worst thing business owners can do is stick their head in the sand. The longer the danger signs are ignored, the shorter the leap from insolvency to business failure.
But for those prepared to take early action, liquidation isn’t the only option. With good advice and a preparedness to make hard decisions on products, clients, processes and staff – including senior management – insolvency can act as a springboard to future growth.
Treacherous times for business owners
Rising costs for things like fuel and falling consumer demand is putting the bottom line squeeze on many businesses, particularly in non-resource exposed parts of the country.
The slowing economy on its own would be enough to trigger a lift in insolvencies, but there is another, unique, factor that could see this downturn hit business particularly hard – the credit crunch.
The ability of businesses to obtain finance to stave of insolvency has fallen to an unprecedented extent, insolvency practitioners say, as banks roll down the shutters for all but the safest prospects.
“Both the main and the second tier mezzanine lenders that once would have provided short term working capital just don’t have the funding because of the credit crunch,” Michael Fingland, managing director of turnaround firm Vantage Performance says.
“That’s the big difference with this cycle. The last time you could still get funds, this time they don’t have money to lend – and that people are hitting insolvency now and not in six months time for that reason.”
While all sectors are vulnerable, history suggest it is smaller businesses, particularly in the construction, retail and business services sectors, that are most vulnerable.
According to ASIC, between 2004-05 and 2006-07, 83% of the businesses that appointed an administrator had less than 20 employees. The biggest share of struggling businesses were in the construction sector, making up 20% of the total, followed by retail and hospitality at just under 20% and business services on 14%.
Anecdotal evidence suggests some businesses in these sectors are already struggling, with several residential building firms moving into administration this year and the recent announcement by US coffee chain Starbucks that it will close 61 of its 865 Australian stores.
Look for the signs of insolvency
Every business owner should know what it means to be insolvent – basically, not being able to pay debts when they fall due – but detecting signs of impending insolvency can be more difficult.
Fingland, an expert in diagnosing the health of a business, says while bottom line fundamentals such as declining profit margins, cash flow and outgoings versus receivables are the usual indicators, non-financial factors can also provide strong pointers to looming trouble.
“A high level of staff turnover is often relevant – staff are pretty smart and in a position to read what is going on, so if they are jumping ship it’s a bad sign. Creditors putting a stop on supplies is also a key warning,” Fingland says.
Looking at the health of a business’s overdraft can also tell a story, Fingland says. The function of an overdraft is to cover short term financial hiccups, so that it then comes to zero over a cycle. So if it is constantly floating near its limit, trouble could be around the corner.
Other signs that a business could be in danger of insolvency include:
- Loss of a major customer (worth 30% or more of revenue) and no replacement in sight.
- Falling behind on lodging BAS returns.
- Constantly paying tax obligations late or being chased by the tax office.
- The personal finances of the business owner are being pushed to the limit propping up the business.
- Persistent late payment to creditors.
- Insufficient revenue to make interest repayments.
- Failure to meet any financial obligations or using limited credit to “juggle” creditors without being able to make any progress on total debt levels.
Time to call in the cavalry?
The first and fundamental rule for avoiding insolvency is this: Be vigilant, and act early.
Insolvency practitioner Sule Arnautovic says the instinctive optimism of the entrepreneur sometimes means they are blind to the true condition of their business.
“Business owners get emotionally involved, and that sometimes makes them too optimistic about potential success and reluctant to see problems,” Arnautovic says.
Ironically, this tendency to optimism can actually accelerate a businesses fall into insolvency because the decisions and changes required to fix things are delayed.
Jim Downey, principal of insolvency practice JP Downey & Co, says the earlier a business owner comes to him with concerns, generally the better the chances that a solution can be found.
“The earlier you see the patient the more you can do for him,” Downey says. “It is too late when they are two months behind with the landlord, they haven’t paid the wages, and repossession agents are knocking at the door. When you see a business in that condition, there’s typically not much that can be done.”
The earlier a problem is detected, the more options the business is likely to have. If insolvency is not imminent, a turnaround specialist may be able to assist management to rescue the business; if the business is teetering on the edge of the precipice, it may be necessary to give up control to an external manager by entering into voluntary administration.
There are differences between the two – most notably, where a turnaround consultant is brought in, existing management and directors remain responsible for ensuring that the business does not trade while insolvent, and are vulnerable to legal penalties if it does.
Voluntary administration has the advantage of transferring liability for things like insolvent trading to the administrator, but it means giving up control over the future of the business.
What turnaround specialists do to save businesses
Whether an external administrator or turnaround specialist is appointed, the first thing they will do is assess the condition of the business to determine if there is any prospect of a turnaround.
If there is no hope, liquidation is the most likely next step, but if some signs of life can be detected, a more extensive process of review and restructuring will be implemented.
Martyn Strickland, managing director with turnaround firm 333 Performance Management, says his work with troubled firms proceeds in three broad stages; stabilisation, consolidation and positioning.
The stabilisation stage involves fixing the business’s immediate problems to prevent an immediate fall into insolvency. This means persuading bankers and creditors to provide some financial breathing space and reassuring staff to prevent mass departures.
It is often crucial to have some external assistance at this stage. Bankers and creditors are unlikely to have confidence in the team that got the business into strife in the first place, while insolvency professionals will often have their own networks they can use to obtain finance.
The next step is consolidation. In the current context, Strickland says, this generally means helping businesses (that grew to be inefficient and inflexible during the recent period of fast growth and easy credit) get back to basics.
“A lot of businesses are in trouble at the moment because they have under-utilised labour and (have) inflexible contracts,” Strickland says. “We help businesses slim down and get back to their core functions. That reduces complexity, gives businesses the focus they have often lost, and brings back the cash flow to start paying down debt, or whatever the problem is.”
Restructuring will also be undertaken at this stage, if necessary. This can mean pulling back from unprofitable product lines, reforming operations, selling off or shutting peripheral operations and, more often than not, shaking up management.
“There’s an old saying that the fish rots from the head, and that applies to business. People are a big part of the problem and the solution, so we often do a talent review of companies we work with, and with that comes either redundancy and/or search,” he says.
The third stage, positioning, is all about ensuring the business is ready to move to the next stage. This will sometimes mean simply continuing to practice the efficient habits that have been instilled in it, but will often mean getting ready for a sale or even a float.
Administration: The beginning of the end, or a springboard to success?
Calling in the administrators is one of the scariest things a business owner can do. It means giving up control and, potentially, putting the decision to close down into another’s hands.
But fear shouldn’t stop a business owner moving into voluntary administration if circumstances require it.
Administration is the best of all possible responses to the risk of insolvency. The alternatives – moving into liquidation, or forcing creditors to impose an administrator – are much worse.
And administration does not need to be the first step in the collapse of a business. Rather, a period of administration can often provide a launching pad to future prosperity.
Listed Tasmanian salmon business Tassal Group is the classic example of a business that has gone from strength to strength following a period of administration.
Insolvency firm KordaMentha was appointed receiver and manager (a form of non-voluntary administration) of Tassal in 2002 after it sustained a $6.2 million loss.
Tassal was struggling primarily because of an oversupply of salmon on domestic and export markets was driving down prices, while a cash flow squeeze meant the company was forced to sell more and more product into the market to keep its head above water.
The structure of the industry was also a problem, with too many small players limiting opportunities for economies of scale.
The solution implemented by KordaMentha was threefold. First, it arranged finance to take the pressure of Tassal’s cash flow problems, removing the imperative to keep pumping salmon into an under-priced market.
It also consolidated the firm’s operations, shutting down loss-making divisions, including its entire Japanese export operation, and putting place a leaner and more effective management structure.
Andrew Malarkey, a partner with KordaMentha who worked on the Tassal receivership, says a management shake-up was central to turning around the company.
“Putting a new team in place was important. Partly it was an integrity issue, because the existing management no longer had the support of its bankers and shareholders. But also for employees it was important to see people coming in with new ideas,” he says.
But the most important decision taken by the receivers – and one even Malarkey concedes was “bold” – was to launch a $30 million acquisition of Nortas, then the third largest salmon producer in Australia and one of Tassal’s key competitors.
“It was a very unusual step, and I think it might have been unprecedented for a business in receivership to acquire another substantial operation,” Malarkey says.
The decision made sense, both because of the economies of scale it would produce and the increased profitability the merged company would enjoy once salmon prices picked up.
Pulling off the deal wasn’t easy, particularly given that Tassal’s bankers had to be persuaded to put more money into a struggling company that was already in debt.
“We had to put together a business plan and persuade them that it was the right move for them and the other creditors,” Malarkey says. “If existing management had asked for the money, they probably wouldn’t have succeeded, but because we were independent and our reputation carried some weight we were able to persuade them it was the right thing to do.”
Once the combined companies were integrated, the company moved out of receivership in 2003 and was sold for $43.3 million. Later that year it listed on the ASX with a market capitalisation of $39.7 million and recorded a net profit after tax of $11.4 million for the seven months to June 2004.
Make the best of bad times
The experience of Tassal shows that businesses can use administration as a springboard to growth. Here are five things owners and managers can do to maximise the chance their business will come out of administration in one piece:
- Don’t delay: The longer you wait to bring in the administrator, the more constrained their ability to fix your business. It also helps your credibility if you have been able to recognise trouble signs at an early stage.
- Maintain relationships: The administrator will probably have to persuade the bank and creditors not to move immediately to wind up the business. If your relationships with those stakeholders are in good shape, the task will be that much easier.
- Get your employees on board: The hard work, patience and ideas of your workforce will be crucial to helping the business rebound. An external administrator won’t have the relationship with them that you do, so getting staff on board can be a key contribution you can make to the turnaround process.
- Co-operate with the administrator: The administrator doesn’t need your co-operation, but it sure does help. If they form the view that the existing ownership and management regime are an impediment to the business’s survival, they will be more likely to seek their removal or to recommend the liquidation of the business.
- Accept the need for change: If a business is insolvent, something has clearly gone wrong. Accepting that mistakes have been made and lending your authority to the solutions will increase the confidence of all stakeholders in the business’s future.