3 top reasons why SMEs become insolvent

According to the business.govt.nz website, about one in ten small businesses fail in their first year, and 70 percent capsize within the first five years. These are sobering statistics.

Most directors that we meet blame the Global Financial Crisis ("GFC") as the number one reason their business failed. Although the GFC was probably one of the causes of the company's downfall it will not have been the main reason. The main reason a company fails is poor management.

It is important for directors to be aware of the bumpy road ahead when starting up their company. Many people are very good at what they do technically, however, they lack the knowledge and know how of running a company.  In our industry we meet a lot of stressed directors of failed companies. A typical interview with a director of an SME usually goes something like this:

Liquidator:  What do you think was the major reason for the failure of the business?

Director:  We just ran out of money and the bank won't lend us any more. We've got some really good jobs coming up but the account is on stop credit. If only the last job paid us on time we wouldn't be in this situation.

Liquidator:  Do you have any financial records?

Director:  They're with my accountant, they will know everything.

Liquidator:  When was the last time you filed your GST return?

Director:  My accountant handles all that.

Liquidator: What do you owe to your creditors?

Director: I don't really know?

We now focus on 3 top reasons why SMEs become insolvent.

1. Poor record keeping/financial control

Many directors do not keep good books and records. They are often too busy creating the company and getting it up and running and fail to capture important data when required. Lack of good records leads to poor and inaccurate forecasting. We find that many SME directors do not know the company's breakeven point or what it is costing them to do a job.

A combination of the above will result in insufficient cash flow for the company which leads to the inability to pay all creditors as debts fall due. This means the company will likely require further capital contribution, or loans from third parties, which will not be forthcoming without showing past results and future forecasts that lenders can have confidence in.

Many companies hire accountants to assist with the financial control of the business. However, it is still the responsibility of the director to supply timely and accurate records.  Without good primary records there is only so much accountants can do to assist.

A good example of what not to do was found on a panel beating liquidation I managed a couple of years ago. The director took over the business from his retired boss. He thought the panel beating prices in Auckland were over the top and decided to charge everyone mates' rates to attract business.  After almost a year the director realised something was wrong so he increased his prices but this led to a decrease in the number of jobs flowing through. It put the business further in debt and eventually led to liquidation. When we picked up the books and records from the office we discovered the creditor invoices were all in a box not filed and the only paperwork that was kept reasonably tidy was the debtors' schedule.

2. Lack of capital contribution

In the current economic environment it is not easy for companies to obtain business loans from banks. This puts more pressure on companies to obtain sufficient capital contributions.

Many companies go into business 'under gunned'. They expect the business to flourish from the first day and fail to take into account the potential losses during the initial growth period and that costs start from day one, while revenue can experience delays. This can also be the result of poor initial planning and due diligence.

The hospitality industry is a good example of what can go wrong from day one. Start-ups often purchase outdated equipment and cut corners on renovation due to lack of funding. This puts stress on the business down the track and results in high maintenance costs, low sales or dissatisfied customers not returning due to a poor initial experience.

We often see businesses run out of cash just when they are starting to generate sales. This can be the result of fierce business competition. Many businesses try to undercut their competitors to gain a customer base.  This can result in a short term loss for the benefit of potential long term success. When the company does not have sufficient capital to support the business during the difficult times then it will encounter cash flow problems.

We were appointed receivers of a skydiving business recently. The director felt the best way to attract customers was to offer the cheapest tandem skydives on the market, much to the amazement of his competitors. What he didn't consider were the deferred maintenance costs required to maintain his aircraft. His business failed when he couldn't afford a $500,000 bill to replace the engine in his aircraft.

3. Directors' lack of commercial acumen

Many people do not take the time to really think about what their life will be like as an entrepreneur. It can be a tough lifestyle at first. They often work twice as hard as they did before, get no holidays and do not make much money to begin with.

As alluded to in the above director interview, some directors have no control over the financial aspects of their company. They may be forced into taking on a directorship to help out a friend or simply "do the right thing" by taking over a family business. In some cases it simply could be due to pride. I have personally experienced a case where the director told me the main reason for starting the business and keeping it running for ten years whilst making losses was to be seen to be "cool" and gain respect from friends and family by owning a company.

Many SME directors are first time directors. They have no previous experience of running a business, no accounting background or prior knowledge of their specific industry. A great cake maker or builder for example, does not automatically make a good director. Without the appropriate professional financial advice and support they may find they lack the appropriate knowledge to run a company. Too often we see cases where directors find they have trusted someone who has let them down or left them exposed through a word of mouth contract. Agreements need to be in writing and signed to be fully effective.

Summary

The world needs entrepreneurs, without them we would have no businesses. We are not trying to discourage anyone from being a director of a company, however it is important they are well prepared when they start a business and seek appropriate advice to ensure the business has the best possible chance of success.

A director entering into business for the first time should seek advice on maintaining books and records and statutory compliance.

Due diligence must be done to ensure the sustainability of the business and obtain the right level of capital contribution.

Should a director or shareholder be personally advancing funds to the company then they need to consider registering securities and attending to the appropriate documentation to gain secured status.

If you or one of your clients is concerned that you may be insolvent then Take our 30 second insolvency test. If you answer yes to one or more of these questions then the company may be insolvent and you should see advice as quickly as possible.

We are always happy to offer advice on insolvency options.

DISCLAIMER
This article is intended to provide general information and should not be construed as advice of any kind. Parties who require clarification on issues raised in this article should take their own advice.

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