25 Insolvency and going concern risk

Need to know

Most businesses will owe money, whether through borrowing from banks or taking advantage of short-term credit terms, available when buying goods or services from suppliers. A company that can pay its liabilities, as and when they fall due, can be described as a going concern. Every company should keep a sharp and continuous focus on its cash position to ensure it can meet its financial obligations as they fall due (see Chapter 24 Working capital and liquidity management). However, as recent history shows, even well-established companies can find themselves in a position without readily available cash when it is required. As a result, businesses can find themselves at risk of insolvency.

Why is this important?

Insolvency can affect a wide range of stakeholders including shareholders, creditors, employees, pensioners, customers and government.

Creditors will suffer financial losses when a company has insufficient assets to meet its liabilities. Shareholders, who carry the highest risk as they are the last to be repaid, will lose monies they have invested in the business (see Chapter 29 Equity finance).

Employees may lose their jobs and may not receive redundancy payments, or they may suffer from pension deficits due to a company’s inability to make good pension liabilities.

Customers are also likely to be affected. For example, when Debenhams announced on 1 December 2020 that it was to close, customers who were in possession of gift cards were given only one month to use their cards, as the business ceased to accept them after 31 December 2020.

Government may lose out due to the company’s inability to pay statutory taxes owed.

When is this important?

Whenever there is a risk of insolvency, directors are legally required to protect the interests of creditors. This is to prevent what may already be a bad financial situation from potentially becoming worse. Directors have a legal obligation to ensure that the company does not continue to trade if it is insolvent.

Warning signs

A company’s directors have a legal duty to ‘promote the success of the company’ and should ensure they have access to information to make informed decisions. This includes identifying warning signs that indicate the risk of insolvency. They must act where there is any risk of insolvency.

Warning indicators can give directors the time needed to secure alternative sources of cash, change strategy or the business model.

Not knowing the company’s trading performance and financial position on a timely basis, for example due to disorganisation or poor quality of financial information, can exacerbate the problem. Directors should implement procedures to ensure they have access to financial information on a timely basis, so they are up-to-date and fully informed on how the company is trading (see Chapter 31 Management accounts). Detailed cash flow forecasts can often provide the best early warning indicator of whether (and when) additional cash will be required by the business. They can also signal a need to adapt or change strategy to ensure business survival over the longer term.

Legal support

Where there is a risk of insolvency, legal advisers will need to be engaged, to advise directors of the actions that need to be taken to protect creditors as special rules come into force.

Assessing going concern and solvency

A company’s audited financial statements cannot and should not be relied on to provide a guarantee of company solvency (see Chapter 20 External financial audit). Financial statements provide a picture of the company’s historic financial performance and situation, of what has been rather than what will be. Financial statements provide limited disclosures and give little, if any, assurance about the future prospects of a business.

Directors are required to include a going concern statement setting out their judgements about the company’s ability to continue operating into the ‘foreseeable future’ (a period defined as being at least 12 months after the date the financial statements are approved).

While the going concern statement is intended to provide some comfort of future continuity, it offers no guarantee of longevity because of the uncertain nature of the future. The Covid-19 pandemic, for example, has shown how quickly a situation can develop and the devastating impact that this can have.

The statutory requirement to report financial information only once annually provides shareholders and stakeholders (such as suppliers) with limited information to assess future solvency. This limitation is compounded by the time taken to publish financial information, anything up to 9 months after the company’s year end (see Chapter 21 Information in the public domain).

It is worth noting that the extent of disclosure around going concern and solvency also varies according to the type of company.

Public limited companies (listed PLCs) are required to disclose additional information about their longer-term viability (see viability statement, below) and include details of the sources of finance available to the company. Private limited companies, by contrast, are required to provide very little information that could be considered useful in assessing their solvency.

Because of these limitations, creditors are likely to turn to credit rating agencies to determine whether to extend credit, or impose alternative trading terms such as ‘cash on delivery’ to eliminate credit risk.

In practice

Company insolvency is not always apparent and cannot easily be predicted. Directors, expected to be continually on alert for risks of insolvency, are often remote from day-to-day business activity. In law, not knowing is not an excuse.

The pace of business change can often take even the most diligent directors by surprise. For example, the emergence of disruptive technologies and their deployment by companies such as Netflix has created significant business challenges (and new opportunities) for long-established, typically high fixed cost, businesses such as Disney and Universal.

External or environmental shocks such as the Covid-19 pandemic could not have been foreseen, yet the effects on business continuity have been both dramatic and quick. Many businesses that have survived have done so by seeking additional and timely financial support or have been able to adapt their business models quickly to survive.

Nice to know

There are two types of insolvency:

• 1Balance sheet insolvency (referred to as technical insolvency). This is when a company’s total liabilities exceed its total assets. A company with positive net assets may suffer losses in one or more years. These losses will deplete the asset base year on year until technical insolvency occurs. In this situation, any attempt to settle the account of any one creditor may prejudice repayment of other creditors because there are insufficient assets remaining to repay all creditors.
• 2Cash flow insolvency (referred to as actual insolvency) is the situation where a company has insufficient cash to repay its debts as they fall due. In cash flow insolvency the company may have sufficient assets but the problem is that it has insufficient liquid assets (i.e. cash) to meet its liabilities. A business expanding rapidly and not collecting cash from its customers quickly enough may find that it cannot meet supplier payments, even though it is trading profitably. This is known as overtrading (see Chapter 24 Working capital and liquidity management).

It is possible for a company to be cash flow insolvent while remaining balance sheet solvent.

In either of the above insolvency situations, however, the company may be placed into what is known as a formal insolvency procedure.

Optional detail

Insolvency procedures

In the UK, any creditor owed more than £750 and not paid for three weeks after the due payment date can instigate a ‘winding up petition’ (a legal notice put forward to the court by a creditor) to place the company into a ‘formal insolvency procedure’. This could result eventually in the winding up of the company.

An insolvent company can be managed in (one of) three ways depending on its likelihood of survival:

• 1Company Voluntary Arrangement
• 2Administration
• 3Liquidation

1 Company Voluntary Arrangement (CVA)

• ■Where there is an intention to keep the business operating.
• ■Carried out under the supervision of an appointed Insolvency Practitioner.
• ■Directors continue to run and retain control of the business.
• ■Creditors agree to a reduced (or rescheduled) debt payment in return for a commitment by the company to restructure under a new business strategy.

The logic for creditors accepting a CVA is that by keeping the business going, there may be some hope of recovering the monies at risk.

2 Administration

• ■Alternative under which a qualified Insolvency Practitioner (‘the Administrator’) takes control and attempts to rescue the company in the interests of all creditors.
• ■Directors lose control of the business.
• ■If nothing can be done to rescue the company, the Administrator will wind up the company and distribute the assets.

3 Liquidation

Liquidation is the process designed to close down the company (cease trading) by converting all of the company’s remaining assets into cash.

• ■Assets are broken up, sold off and distributed to creditors.
• ■Adopted if there is no realistic prospect of rescuing the business.

Viability statement disclosure

The viability statement was introduced following the 2008 financial crisis to provide investors with a better view of the longer-term prospects and solvency of a business. The UK Corporate Governance Code includes a requirement for directors to include a viability statement in the annual report, to strengthen the focus of companies and investors on the longer-term business model. Directors are required to consider an appropriate time period (more than a year) when reporting to shareholders to explain the prospects for the company and the reasons why they consider the company will continue to be viable (see Chapter 22 Corporate governance and whistleblowing).

Given the heightened uncertainties brought about by the Covid-19 pandemic, directors are now encouraged to provide fuller disclosure to support their viability assessment by clearly explaining the company’s specific circumstances and the degree of uncertainty that they face.

The viability statement should be reviewed by auditors and referenced in the audit report.

Providing detailed disclosures covering both going concern and viability is intended to provide investors and other stakeholders with insight into the future prospects of business, in the short and longer term.

Reflect and embed your understanding

• 1Obtain the annual report and financial statements of a plc company in which you have an interest (gov.uk and search for Companies House). Consider the following:
  • aWhat disclosures have been included relating to going concern? What evidence did the directors use to assure themselves that the business would be likely to continue in operation for the next 12 months? How confident can you be as a potential investor that the company will continue into the future based on the directors’ disclosures?
  • bRead the viability statement. How did directors assess the company’s viability? Refer to the audit report contained within the annual report to understand how the auditors gained assurance that the company’s viability assessment was reasonable.
  • cAssess that company’s balance sheet solvency (total assets minus total liabilities) and cash flow solvency (current assets minus current liabilities). Confirm that these support the going concern and viability assessments made by directors.
• 2Choose a well-known company that has become insolvent or search thegazette.co.uk, and select ‘insolvency’ under the notices tab. Obtain the last set of financial statements (and annual report, if available). Check if the accounts were published on a going concern basis and if so, consider if any warning signs were apparent with hindsight.

For the authors’ reflections on these questions, please go to financebook.co.uk

Where to spot in company accounts

Going concern disclosures are included in the financial statements, typically within the ‘basis of preparation’ note (under accounting policies) and explained in the governance section of the annual report and accounts.

In arriving at their assessment of going concern, directors should make sufficient disclosure to support that assessment.

The viability statement is typically located within the governance section of the annual report and accounts.

The validity of the going concern and viability statement and related disclosures should be reviewed by auditors and referenced within the audit report (see Chapter 20 External financial audit).

Extract from Greggs plc 2020 financial statements Appendix p. 451

Consolidate and apply

To see how the concepts covered in this chapter have been applied within Greggs plc, review Chapter 36, p. 418.

Watch out for in practice

• →In addition to the warning signs above, be aware of signs of operational cash flow problems when working in the business. For example, is the company:

  →Ignoring phone calls from suppliers?

  →Having to agree to staged repayment plans, to pay off outstanding debts?

  →Not paying staff wages? As an employee you would be the first to know!

  →Suffering from regular stock-outs? This may indicate supply replenishment problems (suppliers unwilling to offer credit terms).

  →Not maintaining fixed assets or investing in new assets.

  →Having to relinquish assets to bailiffs to settle debts.

• →Financial statements prepared on the alternative (to going concern) ‘break up’ basis. Fixed assets will have to be reclassified as current assets and revalued down to a lower ‘fire sale’ (forced sale) valuation. Additional liabilities may need to be recognised, e.g. for breach of customer or supplier contracts, plus liquidators’ fees.