Business Insolvency – Three Critical Tips To Avoid It
Business Insolvency
There are 3 basic tips that if followed can help you avoid business insolvency.
1. Effective Planning: business insolvency typically occurs because of carelessness in both financial and strategic planning. Effective planning may sound overly simplistic, but every business that approaches financial insolvency has failed to effectively plan their cash flow needs. A lack of strategic planning is typically always present. This is an important element of understanding the strategies that are critical to execute in order to profitably grow a business. Whether a start-up or a solid growth business, if the strategies are not well defined and communicated for executions, the odds are the company could eventually face insolvency. A financial plan relating to strategic targets are typically part of or an outgrowth of strategic planning.
2. Long-Term Credit: business insolvency frequently occurs because companies will negotiate longer than typical periods of credit believing that this will enable them to attract or retain clients. Financially sound companies have an established credit policy and rarely deviate from that policy. A client who cannot pay, or who cannot regularly pay on time, is not an asset to your business.
3. Insufficient Reserves: the only thing in business, as in life, that you can count on is uncertainty. Establishing and preserving adequate financial reserves to provide your business with the necessary liquidity when things go wrong is a business practice that will never be unnecessary. Relying on obtaining the cash from others, especially credit lines from financial institutions, is risky as recent times have demonstrated.
In most cases a business insolvency can be sidestepped by following fundamental and prudent business practices. Business insolvency is generally defined as the financial condition of a company when it has insufficient funds to meet its financial obligations on a timely basis. Companies can face business insolvency for a wide variety of reasons, and these reasons can be both internal and external. Internal factors are typically fully within the full control of the business while external elements are typically outside of the businesses control..
“ There are two very important internal causes for business insolvency:”
1. Insufficient start-up capital and / or working capital can lead to business insolvency:
What Does Working Capital Mean?
A measure of both a company’s efficiency and its short-term financial health. The working capital ratio is calculated as:
Working Capital = Current Assets – Current Liabilities
Positive working capital means that the company is able to pay off its short-term liabilities. Negative working capital means that a company currently is unable to meet its short-term liabilities with its current assets (cash, accounts receivable and inventory).
If a company is a start-up or otherwise has a good working capital position usually defined as a 2:1 current ratio (depending on the industry) it means that it has been properly capitalized and/or is generating a positive return (income instead of losses) from its assets.
If a company incurs substantial losses it results in declining cash and a loss of working capital. This results in the current ratio declining below 2:1 and if it gets less than 1:1 most companies are in serious trouble
Many mid-sized firms find it hard to maintain business even after many years of success. The most common reason for this predicament is typically the lack of effective planning and effective stewardship of available financial resources.
“Most often with start-ups, their initial working capital is proven to be insufficient and the founders have been far too optimistic concerning cash flow projections and the availability of working capital.”
For small companies and high-growth companies, cash outflows are typically always more than its inflows as the business needs to continue to invest in its growth. In such situations, working with seasoned business interim executives like those of Revitalization Partners, who can help you to set realistic cash flow projections to avoid business insolvency is a worthwhile investment.
2. Ineffective Capital Management Can Lead To Business Insolvency
Ineffective capital management usually impacts most companies at some point or another. This is typically the result of poor financial controls, or financial controls that have not kept pace with the growth of the business and the business. Essentially, the business outgrows its ability to monitor and manage its own growth and use of financial resources.
Far too many businesses fail simply because they lack effective financial controls. It is essential that every single business maintain the systems to monitor every monetary transaction and document all of them in a consolidated report so senior management can monitor critical business metrics on a real-time basis.
“All too often, companies fail to invest in the systems and therefore outgrow their own ability to be financially self-aware.”
Proper financial planning will help management understand the impact of forecasted profits, or losses on its working capital and if planning is proactive, management can forecast their cash needs to offset losses, or reduce expenses and capital spending to offset the decline in cash (working capital management). Effective capital/ finance management requires keeping proper tabs on all cash collections and payments in real time, especially for smaller businesses.
Though, business insolvency can affect any company, it is often the case that the smaller the company, the greater the risk of falling into business insolvency. This is because smaller businesses typically lack financial backup plans. They most often find it hard to obtain money from the credit markets because they lack the financial track record that would cause lenders to look favorably upon short and intermediate term financing.
