reduce the risks of insolvency and understand the implications for different business structures

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july 2006

If a business does not have enough assets to cover its debts, or is unable to pay debts when they are due it is insolvent. Insolvency has different possible outcomes for businesses depending on whether they are limited companies or partnerships and sole traders. This article focuses on how to reduce the risk of insolvency in the first place, where to get expert advice should you need it and the varying consequences for different types of businesses.

1) cash flow

Cash flow is a major challenge for many small companies - even when things appear to be going well, cash flow problems can lead to insolvency. To keep cash flowing consider the following ten points:

  • invoice promptly - also try to negotiate regular payments from long-term contractors
  • avoid overtrading - it is tempting to take whatever orders come your way in the hope you can fulfil them, but if you do not have enough cash or resources to do so it will lead to serious financial problems
  • recover debts - don't let unpaid bills linger. Take action and get the money owed to you
  • plan stock reduction - if cash flow problems are serious, cut the amount of cash tied up in stock
  • renegotiate credit limits - try to adjust payment dates and credit limits with your main suppliers
  • factoring - sell outstanding invoices to a third party, known as factors. Factors pay some of the debt off in advance of collection
  • sell assets - consider raising cash by selling under-utilised assets and leasing them back. However you do not want to generate cash flow at the expense of your profit and loss account so check carefully
  • talk to your accountant - t his confidential information will be practical and tailored to your specific business needs
  • consider approaching the bank for extra finance - this is delicate, as you do not want your overdraft called in because the bank is worried about the business. Tread carefully here
  • get cash flow guidance from the many free available sources on the internet -download guidance from the Chartered Institute of Management (CIMA) Accountants website, which is very useful.

2) talk to your creditors, negotiate and compromise

Do not ignore creditors - ever! If they are owed more than £750 any creditor or group of creditors can ask a court to wind up your business. Answer letters and phone calls promptly and discuss problems with payments. If you are realistic and honest a compromise may be possible. Those creditors who are lower down the list of who gets paid in the event of insolvency are most likely to co-operate. If you renegotiate payments but find you still can't meet the payments, contact those involved quickly. Pay as much as you can and assure the creditor you will make up the rest. Perhaps you can renegotiate the deal? Never wait until the deadline has passed before contacting creditors - they will already be angry and much less likely to accept any compromise.

3) reduce overheads

Big cuts in overheads might be necessary to generate cash. Start with advertising, plus any research and development costs as this action can be taken quickly and can have an immediate effect on cash flow.

Staff costs may also have to be cut. Start by restricting overtime or cutting hours. This may reduce staff morale, but is not as devastating as redundancies. If you do need to make redundancies remember that redundancy payments will increase costs in the short term and key employees may feel insecure and go job-hunting. There may be alternatives, and staff can often contribute helpful suggestions when they know their job is on the line.

Other short-term measures to reduce overheads might include delaying purchases of new equipment. This can be tricky. On the one hand you will save money, but on the other investment is crucial if you want to grow your business and ensure it remains competitive. You could also consider letting out part of your business premises - but first check with the owner or mortgage company that sub-letting is allowed and get approval if necessary. As mentioned earlier, leasing equipment and renegotiating contracts with suppliers are other short-term measures for cutting costs.

4) get good advice

At the first hint of trouble, get financial and legal advice. Start with your accountant who should already be familiar with your business, and will have helped others in a similar situation. He or she might also suggest useful local contacts, which could help pull you through.

You must seek immediate advice if you cannot cover your debts, or pay wages or have a severe lack of working capital. Likewise, if the business receives a County Court summons, get help.

The Insolvency Service Website is extremely useful. You can also find an insolvency practitioner there.

If you are a director, seek legal advice. Find a solicitor online at the Law Society website. Directors have to decide early on whether the company should cease to trade and if you do take the decision to continue trading you will need to be sure that the company has reasonable prospects of avoiding liquidation. Remember that directors may be found personally liable as a result of any personal guarantees, and also criminally and personally liable for fraudulent trading (i.e. deceiving creditors) if a company goes into liquidation. Directors are also personally liable for wrongful trading (i.e. trading while the company is insolvent), if the company goes into liquidation. Criminal charges could follow and directors may be disqualified if found liable.

what happens to businesses that become insolvent?

If insolvency is unavoidable you need to consider how to deal with it, and this will depend on whether the business is a limited company or a partnership or sole trader. There are different options and consequences for each and all are discussed below.

possible outcomes for limited companies

The options available include liquidation (either compulsory or voluntary), administrative receivership or administration.

A business ceases trading when it is liquidated and its assets are sold to pay creditors. As mentioned earlier creditors owed more than £750 can ask the court to wind up your business. This is known as compulsory liquidation.

A company can also apply for voluntary liquidation where the shareholders can decide to wind to the business and ask the creditors to appoint a liquidator. If a company wants to make voluntary arrangements you can use an insolvency practitioner to prepare and negotiate an agreement between you and your creditors. This is a schedule of when you will make repayments to creditors. A meeting will be held to present your proposals to creditors and 75% (by value) of creditors must vote (this can be by proxy) in favour of the arrangement for it to be binding on all parties.

Administrative receivership is another possible outcome. This is where the receiver takes control of the business. The receiver decides whether to attempt to sell the business as a going concern or shut it down. Only a secured creditor, such as a bank, can appoint a receiver, although directors cab also ask for a receiver to be appointed, for instance to avoid the risk of wrongful trading. Administrative receivership is only available for limited companies.

administration

The administrator may be appointed by the court, certain specified creditors or the business itself. The administrator has a specific job, which is firstly to rescue the business. If this is not practicable then the administer needs to achieve a better result for the business' creditors as a whole than would be achieved in a winding up. If neither of these options is workable the administrator has to do his or her best for the secured and preferential creditors without unnecessarily harming the interests of the creditors of the business as a whole. The administrator runs the business and calls a creditors' meeting to decide what to do next.

possible outcomes for partnerships and sole traders

Individuals have slightly different liabilities if they become insolvent. Indeed it is why many people prefer the protection of a limited company where they can limit liabilities. There are three options: bankruptcy, individual voluntary agreement or partnership insolvency. Bankruptcy is the procedure for an individual to be declared insolvent and if you trade as a sole trader, in a partnership or have given a personal guarantee for the debts of a limited company, you are liable for these debts and can be made bankrupt. An insolvency practitioner or the official receiver takes control of your estate, acting as trustee and sells or converts your assets to pay creditors.

The alternative to this is to reach an individual voluntary agreement with your creditors. This usually means that a schedule of prepayments has to be approved at a meeting of creditors. At least 75% (by value) of creditors present or by proxy must vote in favour of the arrangement for it to be binding on all parties. If you want to take this route you will need to use a licensed insolvency practitioner when preparing your proposal to the creditors. The proposal is normally a schedule of when you will make repayments

Insolvent partnerships can be dealt with by liquidation, partnership voluntary agreements or administration and an insolvency practitioner can advise on the best route and steps to take.

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about the author

Heather Harrison is a highly regarded member of the Duport team. Her thorough knowledge of small businesses, combined with her talents developed during a career as a well respected journalist, make her articles very popular with our readers. Heather has worked on a variety of weekly and monthly magazines, both in the consumer and business press.

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