Keeping good company: financial risk assessments
“In God we trust, all others pay cash.” The famous line, first used by the Philadelphia Inquirer in 1877, makes a valid point - how can a business ensure that it’s going to get paid? Fortunately, creditors of Bedworth Haulage picked up on rumours of trouble at the company in the weeks before it entered administration in February.
As reported by CM at the time, AD Boyes Haulage Logistics clawed back most of the £4,000 it was owed before the administration. Others may not have been so lucky. Delayed payments are much harder to recover when a customer operates via a corporate shell.
Unless there are personal guarantees, or wrongful trading or fraud can be proved, the debts of an entity stand distinct from the assets of the individual. In exchange for this protection, incorporated entities must put certain information, including company accounts, into the public domain.
Peter Windatt, a director of BRI Business Recovery and Insolvency, notes that company accounts are simply a record of trading activity and, he says, in practical terms the basics of accountancy are the same for all businesses. “Differences arise when assets are acquired through different mechanisms such as by lease, contact hire, and lease purchase, and when assets are sold using different methods such as sale or return, consignment stock, sale and leaseback,” he says. Each is treated differently for accounting purposes.
It is for this reason, he says, that accounts “enable an informed user to form a view as to the performance of a company over a period of time through the profit and loss account, and to form a view as to its solvency at a given moment in time via a snapshot of the balance sheet that at, its simplest, lists assets against liabilities”. While accounts can help form an opinion, they are not required to look into the future.
“Detailed reports and accounts for a PLC will differ greatly from a small one-man band as the disclosure requirements get more onerous the bigger a company becomes”, says Windatt. “For the average company there are no significant future-gazing requirements.”
Accounts should therefore be read with a pinch of salt, says Stephen Diver, manager, financial reporting advisory group at Grant Thornton UK LLP. “It is possible to review trends in a set of accounts, as typically two years of information is disclosed, and previous statutory accounts may be downloaded from Companies House.”
Diver says that when assessing trends it is important to read all information in the statutory accounts, for example a one-off event could lead to a significant profit or loss in a single period. This would not be indicative of future performance and should be disclosed in the directors’ report in the accounts.
As to what else an operator should be looking for, this will vary greatly with the nature of the business being considered. Windatt says: “Being able to analyse one company in a sector against others from the same sector is much more useful than comparing a company to all companies.”
Something else to consider, says Diver: “Abridged accounts will not include a profit and loss account. As such, performance may be more difficult to assess for smaller companies.”
He says an alternative is to calculate the movement in retained earnings between the two years disclosed, because in most instances this will equal the profit or loss for the company. However, as other items may be included in this movement, it is not an exact measure.
Accounts can highlight large creditor balances. Could it be a problem for a debtor company? Maybe, but only when a large creditor believes it to be so.
For others the problem will only become apparent when there is an action to wind up the company; debts above £750 and a company that does not have the cash to pay can be cut down.
A legal definition of insolvency is found in section 123 of the Insolvency Act - either assets are exceeded by liabilities, including contingent and prospective; and/or the company is unable to pay debts as and when they fall due.
Fundamentally, says Windatt, the adage turnover is vanity, profit is sanity and cash is reality is not too far from the truth; “anyone can sell at a loss - profit is good on paper, but not a sign that you will survive if you can’t get the cash in from those who owe you”.
Accounts are just part of the story as firms should know what type of business they are dealing with - a sole trader, partnership or some form of limited company. Windatt says: “Don’t be reassured that a firm’s accounts say it is ‘part of the XYZ group’ because that only means it is a kite, which, if it doesn’t fly as it might like, it can cut the string on and watch it fall with little damage to themselves.”
He also says to look for the obvious such as too many round figures. “Look for a sudden change in something; anything. See if debtor days are rising: they are selling but not getting paid.
Do the same for creditor days: purchases are not being paid for. Also, look for changes in the board room, remembering that some firms might not record changes at Companies House, which is riskier still.”
Diver advises looking at gross margins (profit) levels driven by cost savings; fully depreciated fixed assets that need replacing soon; loans that need repaying within 12 months and whether the business has the money to do so.
And see if there are any related parties that have loaned sums to the business or if any sales or costs are associated with them. “It is important to look for consistent losses, particularly if accompanied by a declining trend.
“An increase in liabilities may not be an issue if this is to fund, for example, capital expenditure but it’s likely to be a concern if funding losses,” Diver says.
In some cases, the directors’ report might provide some insight into the reasons for losses or increases in liabilities. A quick search at Companies House will show a variety of forms of company accounts - some long, some short.
Should a short set of accounts be viewed with suspicion? Windatt thinks not: “If directors are acting wrongly, they won’t file accounts or will make them up and wait for someone to catch up with them.”
Remember, Companies House is just a repository of information, it does not fact check. With accounts it is important to take a nuanced view as risk is a function of doing business on credit. Do your homework, take an informed view, and then do what you think is likely to be for the best.
By Adam Bernstein