Five early signs of company insolvency

Five early signs of company insolvency

The top 5 IP mistakes growing businesses make, and how to avoid them

Amidst the cost of living crisis, businesses are folding in record numbers, with barely a week passing without news of a big company casualty. Paperchase is the latest retailer to collapse into administration, with the business being snapped up by Tesco for sale in its superstores and 820 jobs reportedly at risk. So how can we identify the businesses that are in the danger zone and could be heading for insolvency?

1. Profit warnings

Often we hear in the press about companies issuing profit warnings when the business has underperformed against forecasts. Direct Line, for example, has issued three profit warnings in recent months, with inflation increasing the cost of claims, and the recent cold snap apparently responsible for an increase in customer claims. The number of profit warnings issued by UK-listed companies rose by 50% in 2022 according to research by EY.

2. Late filing of accounts

When a company fails to file its accounts on time, it can indicate a lack of proper financial control or the directors simply burying their heads in the sand in the midst of financial difficulties. The company may be unable to reconcile its assets and liabilities – in particular, contingent liabilities related to ongoing litigation. More likely, though, the directors have been unable to satisfy the auditors that the company has sufficiently committed funding in place to support a 12 month "going concern" opinion. Directors are acutely conscious, of course, that their key suppliers, customers and funders will be watching like hawks for any qualification to their published accounts or any indication of "material uncertainty". Either is likely to lead to covenant breaches being called, to customers declining to sign up to new contracts and to suppliers tightening or withdrawing credit terms. In short, directors find themselves between a rock and a hard place. Failure to publish accounts on time generates counterparty anxiety, as well as - increasingly – threats of prosecution from The Registrar of Companies, but timely filing of qualified accounts (or of accounts containing "material uncertainty" statements) can lead to an unseemly stampede for the exits.

3. Management team changes or high turnover of staff

It is not unusual to see a new manager appointed at the helm of ailing businesses, as many credible turnaround plans require a new management team. However, the timing of the changes can raise questions where firms are also displaying other financial warning signs such as profit warnings or seeking additional funding. Seasoned turnaround managers often flourish in this pressurised environment, of course, but for executives not familiar with operating in a "distressed" environment, it can often be a chastening experience.

4. Operating in a contracting market

Shrinking markets or a loss of consumer confidence will have an effect on businesses. This has been seen recently in the retail and aviation industries, with the likes of Joules and Paperchase amongst other high profile retailers entering administration. In those cases, both companies suffered store closures after the businesses were purchased out of administration by existing brands (Next and Tesco respectively) to sell as concessions within their stores or online. A similar fate has recently befallen FlyBe, which recently entered administration for the second time, as it struggled to return to profitability following its relaunch post-pandemic. Many other airlines have been forced to increase fares or otherwise reduced ‘frills’ such as free hand luggage in order to recoup losses during the pandemic and last summer when airports struggled to scale up capacity to meet increasing demand. On a more positive note, it is significant that, even in these distressed sectors,  when firms fail, prospective investors  - often big players in the sector - will rapidly show interest in picking up at least some of the pieces (if not all of the lost jobs) – take a bow, Tesco, Next, Lufthansa and Air France!

5. Late payments or seeking additional finance

Increasing creditor pressure, failing to make payment deadlines and seeking extended lines of credit are all signs that a company is facing cash-flow difficulties. Perhaps the most obvious sign of potential financial distress is a winding up petition being presented against a company, which then can cause the company’s bank accounts to be frozen. One option for businesses in financial difficulty is reverse factoring or invoice discounting, whereby the company’s bank pays its creditors, with the company subsequently repaying the bank (with uplift). Famously, Carillion had accumulated a liability of circa £500m under its early payment facility programme by the time it entered liquidation in 2018.

Any of these signs in isolation is not necessarily indicative of insolvency. However, where two or more signs are present, or there are other factors at play, it could be cause for concern. Any business struggling with its finances should seek early independent advice.

This article has been published on LexisPSL and can be accessed here

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