Introduction
This article is in addition to the many that I have written before on insolvency. In this article I look at the factors that may lead to financial distress or insolvency of businesses. Insolvency proceedings in the form of corporate rescue or liquidation are done in terms of the Insolvency Act (Chapter 6:07), or “the Insolvency Act”.
Insolvency versus financial distress
A business is said to be insolvent if it is unable to settle its debts as they fall due. This may also include situations where the liabilities of the business exceed the business’ assets. According to section 121 of the Insolvency Act, “financially distressed”, in reference to a particular company at any particular time, means that:
- It appears to be reasonably unlikely that the company will be able to pay all of its debts as they become due and payable within the immediately ensuing six months, or
- It appears to be reasonably likely that the company will become insolvent within the immediately ensuing six months
According to the Act a business that is insolvent can be liquidated while that which faces financial distress but there appears to a reasonable prospect of rescuing it can be place under corporate rescue proceedings.
Factors leading to financial distress or insolvency
These factors can conveniently be grouped into two groups, namely:
- Internal factors and
- External factors.
Internal factors
Some of the internal factors that may lead to financial distress or insolvency include the following:
- Lack of expertise or experience in running a particular type of business.
- Corporate governance failures.
- Poor financial management.
- Poor procurement systems.
- Default by significant debtors.
- Lack of working capital.
- Failure to manage debts or gearing.
- Loss of a major contract or client.
- Capacity constraints.
- Strategic management failures.
Lack of expertise or experience in running a business
It is possible to promote from within executives who may not have the higher level expertise required to run the business. It is also a common mistake to hire external people who do not have experience of the particular industry or type of business who may not have operated at the same or equivalent level before. This is particularly so in the case of a Chief Executive Officer, Chief Finance Officer or Operations Director.
Corporate governance failures
Proper corporate governance systems provide checks and balances. Lacks of proper corporate governance systems or existence of those that are compromised may result in wrong decisions or financial prejudice to the business.
Poor financial management
This is usually the main reason for many failures. This may be due to situations such as:
- Committing to capital expenditure funds that should be used for working capital.
- Failure to manage operating and other business costs.
- High gearing and failure to manage the debts. Debts many also include taxes.
- Failure to collect amounts due from debtors.
- Financial leakages through misappropriation of funds, related party transactions such as insider loans or poorly priced transactions, too high drawings by owners of the business, etc.
- Incorrect pricing of goods and services.
- Failure to preserve value of surplus funds.
- Failure of new high risk ventures or projects.
- Strategic management failure
Poor procurement systems
Procurement systems are do not result is cost effective or best prices for the business will soon erode the business’ cashflows. It is worse when such systems are compromised through for example collusion with suppliers.
Loss or default by major debtors
If major debtors are lost or they fail to pay, a company’s cashflows usually suffer.
Lack of working capital
Working capital is the life blood of a business. It is money that is used on a daily business. Working capital may be affected through loss of supplier credit, supplier price increases, reduction in selling prices, funds used for capital expenditure or settle debts, misappropriation of funds, high operating costs, inability to access bank loans, etc. Lack of working capital usually affects product volumes.
Incorrect pricing of goods and services
Wring pricing of goods and services particularly where different currencies are involved. Some long establish business pricing models fail to factor in new realities of business.
Failure to preserve surplus funds
Some finance people may fail to preserve the value of surplus funds which may then be affected by inflation or currency changes.
Strategic management failure
Some business fail simply because management fail to deal with internal of external factors affecting the business. For example, some businesses may complain about the external factors or operating environment while competitors in the same environment are doing well.
External factors
External factors affecting businesses which may cause financial distress or even insolvency are political, economic, social, technological, environmental and legal (“PESTEL”). Economic factors may include currency changes, inflation, liquidity, changes in consumer buying power and interest rate changes. Technical changes are inevitable and may create new opportunities while others are lost. Social changes may affect customer preferences, etc. Failure to manage changes in the external factors may sink a business.
Conclusion
Financial distress or insolvency of a business may be caused by the factored explained above.
Disclaimer
This simplified article is for general information purposes only and does not constitute the writer’s professional advice. It is general and not specific to any entity or people.
Godknows (GK) Hofisi, LLB(UNISA), B.Acc(UZ), Hons B.Compt (UNISA), CA(Z), ACCA (Business Valuations) MBA(EBS, Heriot- Watt, UK) is the Managing Partner of Hofisi & Partners Commercial Attorneys, chartered accountant, insolvency practitioner, commercial arbitrator, registered tax accountant and advises on deals and transactions. He has extensive experience from industry and commerce and is a former World Bank staffer in the Resource Management Unit. He was recently appointed to sit on the Council of Estate Administrators in Zimbabwe. He writes in his personal capacity. He can be contacted on +263 772 246 900 or ghofisi@hofisilaw.com or gohofisi@gmail.com. Visit www//:hofisilaw.com for more articles.
