Insolvency - going concern - overtrading
Insolvency is the inability to pay debts as they fall due in the normal course of business and/or having liabilities in excess of the realizable value of net assets held. This definition points to the two principal reasons for insolvency: (1) lack of free cash from trading and (2) lack of available cash as liabilities exceed asset values. These are the principal reasons picked up by the concept of 'going concern', as explained in Chapter 5.
When preparing financial statements, the management of an entity shall make an assessment of the entity's ability to continue as a going concern. An entity is a going concern unless management intends either to liquidate the entity or to cease trading, or has no realistic alternative but to do so.
The causes of insolvency can be many and can be sudden or creep up on a business. An example of a sudden change is an unexpected, disastrous event leading to a successful legal claim against the business, with the liabilities far exceeding the value of assets, for example a petro-chemical works explosion not fully covered by insurance. An example of a creeping insolvency is a relentless decline in business with no prospect of recovery or blindness to the situation, for example shops selling DVDs when customers have moved to online downloads.
Risk management procedures are aimed at identifying possibilities of rapid or creeping change which might lead to insolvency.
When a business grows very rapidly there is the danger that there will be insufficient working capital to fund receivables and also inventory. The example shown below does not even consider the need for stockholdings, but the rapid rise in sales in scenario B causes cash flow problems related primarily to funding receivables.
Table 8.5 is an example of Business A, which has steady sales; 7,000 is needed to fund two months' overheads and one month's supplies before debtors pay.
The 7,000 was the sum required at the outset to ensure that cash did not fall below zero in month 2.
Business B experienced rapidly growing sales and increasing overheads (Table 8.6), and the trading terms are similar to the steady state as demonstrated in example A.
The 7,000 here is inadequate to fund the additional cash flows for increasing overheads and payables while awaiting the increasing receivables to flow in. The result might be insolvency before cash flow turns positive.
TABLE 8.5 Working capital requirement - steady state
TABLE 8.6 Working capital requirement - rapid growth
The management of cash generally and working capital in particular may often be rather pedestrian, but it is essential if a business is to be sustainable. Looking at working capital constituents from the perspective of days of inventories held, days before you are paid by customers and days before you have to pay suppliers may assist in understanding how overtrading or growing too fast can lead to disaster.