Businesses can become insolvent many different ways, whether it’s by suddenly racking up too much debt or through not generating enough income from the sale of products or services to keep up with the payment of bills. When a business cannot meet its obligations because it doesn’t have enough income or cash flow, it’s called “cash flow” insolvency. When a business has obligations worth more than it has in assets, it’s “balance sheet” insolvency. The IRS puts the second one plainly: “a taxpayer is insolvent when his or her total liabilities exceed his or her total assets.” It matters which side of that line you are on, because running an insolvent company can even lead to personal liability for the company’s debts. Delancey Street negotiates with funders, lenders and other creditors for small business owners. These are the seven signs we would tell any owner to watch for.
Sign of Insolvency
The first is poor cash flow combined with ongoing losses. If you are losing money, no matter how you think you will improve cash flow in the future, cash flow will become a problem. If the cash flow problem is temporary, then the company may not be insolvent. But if losses have been chronic and cash flow is chronically negative, or if it continually accumulates debt and falls behind, then it’s at risk.
The second is that you can no longer cover basic operating costs. To keep the lights on, keep the doors open, and pay employees, your business needs enough cash flow to cover all of its basic operating expenses. If your sales and revenue don’t cover the basic costs of operation, such as utilities, rent, payroll, etc. then it’s a warning sign you may be entering the financially dark side of the moon.
The third is that you can’t pay your creditors on the terms you agreed to. Sometimes a balance due on an invoice will be late because of a slip-up. But if you regularly miss the deadline for paying an invoice by more than a few days, it’s probably because the money you’d have to use to pay it is being put to some other priority.
The fourth is a steady stream of legal threats. When a business stops paying its bills, its creditors get upset. When a creditor threatens to sue you over an unpaid bill, then that is another sign of insolvency. If you are hearing “thunder” more and more frequently, there are reasons for concern.
The fifth is borrowing to stay current. If you keep borrowing money to pay creditors and make payroll, that is also a sign of insolvency. Why are you borrowing more money? Because you don’t have enough revenue. That’s a tell-tale sign. If your business’s cash flow cannot keep up with its obligations, you may be faced with the dilemma of borrowing more money to pay down what you already owe.
The sixth is a court order you can’t satisfy. A court order to pay a debt makes it clear that your business is in trouble. This is probably obvious, but there is a big difference between a creditor mailing you a reminder that you owe a bill and a court judgment from a creditor. This is a serious advance on insolvency. It means a creditor has sued you, won the case, got a court order, and you still can’t pay.
The seventh is the most basic. If you own a house and owe more on the mortgage than the house is worth, the house is “underwater.” The same is true of business debts. If the total value of your debts is more than the total value of your assets, you are insolvent.
Two Simple Tests
So how do you check? There are two simple tests. The first is the balance sheet test: list all the company’s assets in one column and its liabilities, including prospective and contingent ones, in the other. If the company’s liabilities exceed its assets, then the business is insolvent. The cash in the business’ bank accounts is clear-cut. The balance sheet test values all company assets at what they are worth if they were being sold off. In the case of a vehicle, this means it is worth its black book value, that is, what it would bring if it were sold to a private dealer. If the company can’t pay its bills but has assets to sell, it’s not considered insolvent under this test. The second test is called the cash flow test, and it measures a business’ ability to meet its obligations as they fall due. This test is different in that it looks at the future. Cash flow is always shifting. Under the cash flow test, a business needs to determine its working capital at a point in time, and compare that amount to its projected sales and its projected expenses.
Keep Your Business Afloat Without Bankruptcy
If you believe your business is insolvent or heading that way, pay close attention to your creditors. Creditors have a big interest in getting their money back. Some creditors will let a business restructure its debt into a payment plan it can manage. You can negotiate with them directly. Or consider enlisting a third party to negotiate on your behalf. At the same time, stop making the hole deeper by keeping new borrowing to a minimum. A common mistake when things get tight is to try to keep the company running and see if something will turn around. But if the business can’t pay its bills, keeping the doors open might not be the best move. Work on the cash coming in, too. As soon as you deliver a product or perform a service, issue an invoice for the amount due. That makes it as easy as possible for the client to pay you. Then start collection efforts on all accounts receivable, check what financing options you have, and improve the financial information you run the business on, so you know where you stand.
Business owners should have their finances evaluated regularly to see if they are insolvent and, if so, get advice. An accountant or an insolvency expert can take a look at your books and give you a no-nonsense assessment of your financial condition, where you are and where you are heading. They may see an opportunity to keep your business afloat without bankruptcy. A near-bankrupt business owner can try to salvage the business by refinancing, restructuring or appointing an external administrator. Alternatively, a turnaround expert can be hired to find out what’s going wrong, suggest solutions and negotiate with creditors. If a company is insolvent, it may be put into liquidation. This can be done voluntarily by the directors and conducted by an insolvency practitioner, or it can be done by a creditor, through the courts.
At Delancey Street, our senior advisors will negotiate with lenders for an amount less than the total owed. We don’t give our clients another loan. We are not a law firm, so if a company really needs to file for bankruptcy we straight out say that on the first call and direct the owner to an independent lawyer we trust. That first consultation is free and confidential. If a business is in trouble, there’s often a window of opportunity when things can still be turned around. Of course, the longer the business waits to take action, the more difficult it will be to save it.
