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Insolvency and Bankruptcy

This resource seeks to help guide you through some of the issues surrounding the idea of insolvency. Most businesses when starting up might dream of success and profits. The reality in some cases is much less romantic: 20% of new businesses fail within the first two years of operation. In many cases, this is due to problems of cash flow rather than the business idea being wrong.

Strictly speaking, insolvency is the term we should use to describe the difficulties businesses face, whereas bankruptcy refers to the position an individual faces when unable to pay their debts. The two terms tend to be used interchangeably, and the basic problem is essentially the same.

Some Key Terms

  • Assets - all the things that a business owns that have some value. This could be equipment, buildings, machinery, land, a brand name or even an idea that someone is willing to pay for.
  • Liabilities - all the things that a business owes to other people. This could be loans to a bank, payments for raw materials, tax owed to the government and so on.
  • Liquidity - The ease with which an asset can be turned into cash. This is important to enable a business to have the flexibility to be able to meet its debts.

What is Insolvency?

All businesses have revenues coming in from sales and money going out to pay for raw materials, staff, insurance, administration, advertising, loans and so on. The amount of money coming into the business, and when it comes in to the business, is crucial to allow a firm to be able to continue operating in the longer term.

Expenditures tend to be fairly regular in occurrence - insurance, staff salaries, rent and rates, for example, have to be paid at least monthly and raw materials used will depend on the level of production. If a business faces an increase in demand for its products, it may have to order in more stock and it needs the funds available to be able to do that.

If, for some reason, revenues are not coming in at the same rate then the business can start to experience problems. Without cash coming in, creditors (people who are owed money by the business) do not get paid and legally they can take steps to recover this money. If this happens then the business faces insolvency - an inability to be able to pay off their debts.

Cash Flow and Profitability

A business can be profitable in that, over a period, its costs are less than its revenue. However, if during that period it is unable to meet its obligations, then it can face insolvency. Profit, therefore, is not the same as cash flow.

What Happens when a Firm Becomes Insolvent?

There are various stages that a business might go through when it becomes insolvent. It will have taken various steps already to try and deal with the problem but if some legal action is being taken, it may have got beyond the stage where the firm itself can cope with it and some outside assistance may be required.

If it gets to the position where it has tried to deal with the problems it faces but has to accept that it will not be able to do so there are a number of possible routes it can take.

  1. Decide to go into liquidation. This will involve selling of the assets of a company in order to try and pay off creditors. There are various forms of liquidation:
    • Compulsory liquidation. In this case, one or more of the creditors will have gone to a court to get their money. The Court issues a winding up order that forces the business to close down and take steps to sell off its assets.
    • Members' voluntary liquidation. This occurs where the company has sufficient assets to cover its liabilities but the shareholders decide to put the company into liquidation. The implication is that the shareholders are not confident of the longer-term position of their business and decide to cut their losses.
    • Creditors' voluntary liquidation. In this case, shareholders have decided to put the company into liquidation but they face a situation where they do not have sufficient assets to cover their liabilities.
  2. Informal Arrangements. Here the company might contact its creditors advising them of its position and seeking to come to an agreement about arrangements to settle its debts.
  3. Company Voluntary Agreement. Similar to the informal arrangement but the company would use a court to formalise it. In such cases a specialist Insolvency Practitioner (IP) will be employed to see through the agreement. An IP must be registered and will often be part of a firm of accountants who specialise in dealing with company failures.
  4. Administration. An application to a court by the company to suspend the requirement to pay creditors for a period of time. During this period of time, the company will be administered by an IP and it will be their job to either find a new buyer for the business or parts of the business, negotiate with the creditors to restructure the debts or oversee the liquidation of the assets to pay off creditors. Going into administration gives the firm some breathing space to help deal with its problems and can result in the firm surviving albeit probably in some different form than before it went into administration.
  5. Receivership. In this situation, the creditors can ask for a receiver to be appointed to sell the assets of the company and thus pay off the creditor. The receiver's job in this case is purely to recover the debts of the creditor. Once this has been done the remains of the business is handed back to the owners.

Task

You are going to work through various exercises to help build your knowledge of this area. The tasks will include a look at cash flow, solvency ratios to measure the extent of the risk that a business faces and finally a task that will allow you to be able to develop a piece for your portfolio.

  1. Follow through the 'Cash Flow Learning Trail'(http://www.bized.co.uk/learn/business/accounting/cashflow/trail/cashflow.htm) - this will take you through the main principles of cash flow. The resource contains notes and questions to help you assess your understanding.
  2. You will work through the relevant section of Biz/ed's Ratio Analysis section. The parts you need to work through are on Working Capital Management 1(http://www.bized.co.uk/compfact/ratios/liquid1.htm) and Working Capital Management 2(http://www.bized.co.uk/compfact/ratios/sdc1.htm). These activities will cover the main solvency ratios you will need to understand.
  3. Now put your skills and understanding to the test by following through the Cash Flow Simulation(http://www.bized.co.uk/learn/business/accounting/cashflow/simulation/index.htm). This is a simulation based on a fictitious small firm. Your task in the simulation is to complete the cash flow forecast and then manage the cash flow of the business for a period of a year. There are full instructions for running the simulation in this resource. It is possible to make this quite a complex task but if you are aiming for a distinction grade then it is important that you think through your decisions, record how and why you made the decisions you did and reflect on them.
    • As you are going through the simulation you will get feedback on your performance - if things start to get a bit difficult and it looks like you are going to experience cash flow problems then you will be warned. Note that if you ignore these warnings or make the wrong decision you could end up going bankrupt! In following through the simulation use some of the solvency ratios you have covered to check the financial health of your company.
  4. Prepare a report on your experience of the cash flow simulation. Your report should:
    • Evaluate your performance, what the outcome was, where you might have made mistakes and how you might have done things differently given your experience.
    • Evaluate the methods you used to source finance to manage your cash flow.
    • Show how you used solvency ratios to be able to monitor the performance of the company and evaluate the usefulness of these measures.

Completing these tasks should give you a thorough understanding of all aspects of cash flow and managing working capital. If you managed to survive the year then you can congratulate yourself - but remember it is important to be able to evaluate why you were successful.

If you ended up bankrupt then it is important that you demonstrate an understanding of how you ended up in this position and then offer some explanation of what the possible routes might be for your firm in the circumstances. Evaluating these routes will be an important part in demonstrating your understanding of insolvency.

Useful References