Welcome to the May 2008 edition of "The Director's Dilemma" Newsletter. I hope you find it interesting, informative and inspiring.
In the course of my work advising boards and directors I encounter complex and challenging issues which can be resolved in a variety of different ways. Each way has different pros and cons for the individuals and companies concerned. Every month this newsletter addresses an issue with the assistance of some governance experts that I admire and enjoy working with. Compare the various possible responses to the situation. Which response would you choose?
Here is this month's "mini case study":
Susanne is a director of a small family company that has operated reasonably successfully for about eight years. Demand for the company’s product is strong and growing. Recently cash flow has been tight and the company has delayed payments to creditors and not submitted a couple of BAS statements so as to use the net GST that would otherwise be paid out.
The accountant has just shown her the annual accounts and asked her to sign the solvency declaration. Although the management team and her board colleagues assure her that the business fundamentals are good, she is concerned about the implications of signing under the current circumstances.
What should Susanne do?
Susanne cannot sign the solvency declaration at present because the company seemingly cannot pay its debts ‘as and when they fall due’, no matter how good the ‘business fundamentals’ are. This is very clear from the delay in paying the net GST due on the last two BAS statements, let alone the delay in paying creditors. The company must immediately prepare a cash forecast to determine what the cash position is, and when cash could become available to clear the overdue BAS statements, meet forthcoming cash payments, and bring creditors into an acceptable position. This action will determine if the company is in fact solvent.
Further financial support seems essential to achieve a position where debts can be met in a timely fashion. In the case of a small family company, the family must be the first port of call. If the family cannot provide further support, and further cash cannot be generated within the business, then outside support must be sought. On the basis that the company’s product is strong and growing, it should be possible in the short-term to approach the company’s bankers for financial support, or in the medium term a private investor or another company providing loan finance or as a shareholder providing share capital. If these actions are not successful, the company must seriously consider its future viability. If in fact the company appears to be trading whilst insolvent, the directors, including Susanne, may be personally liable under the Corporations Act for civil action by creditors to recover any debts.
Until the cash position of the company can be clarified, Susanne should not sign the solvency declaration. To sign the declaration exposes Susanne to civil actions for damages if it can be proven that she knew, or should have known, that the company was incurring debts that could not be paid as and when they fell due. The directors must take immediate action to ensure the company is solvent.
David Sharland has held Chief Financial Officer positions in the public and private sectors, is an experienced company director, and a popular presenter of AICD education courses.
Sadly, Susanne is responsible regardless of whether she signs anything. A director will be liable for debts incurred if the company trades whilst insolvent even if she doesn’t sign a declaration. A company is insolvent if it cannot pay its debts when they are due.
Although you sign a solvency declaration every year you should check that your company is solvent in between declarations. In Susanne’s case you have some clear warning signs:
- Payments being delayed
- GST being used rather than set aside for payment
The first thing to do is to meet the ATO and ask to arrange to officially defer tax payment whilst she sorts things out.
Susanne needs to know exactly what is happening. If demand is strong and growing it may just be that the company is under capitalised for the current volume of work. She needs more than just ‘straight’ financial reports. Knowing what it costs to supply each product or service and what each product or service is worth to the customer will help her to understand if pricing is the problem. An understanding of payment terms and debtor days or inventory turns will help her to know if debt collection or ‘manufacturing to inventory’ is a problem. What are the competitors offering and charging and how are they faring in the current market? What do the successful competitors do that her company doesn’t?
Is it worth putting more money into the company to solve the problems? Can the rest of the family help? Should the board look for a buyer who is more able to run this business profitably and get the family out of this business?
To answer these questions, in a small family business, Susanne probably needs to get out and ask the staff, the customers and the relevant industry association how they perceive her company. In a larger business she might be able to use a consultant but, if she can’t afford one, she must ask these questions herself. The answers may not be as nice as the assurances she is currently getting but they just might keep her out of trouble.
This is not the time for the board to be passive. Susanne, and her colleagues, must act.
Judging by the accountant’s request that Susanne sign a solvency declaration and the difficulty the business has paying its creditors it may be technically or actually insolvent. Insolvency is defined as an inability to pay debts when they fall due.
Susanne should be aware that as a director of a company that trades while insolvent, she can be held personally liable for the company’s debts. She should carefully consider the situation before signing a solvency declaration.
The business appears short of working capital (trade debtors plus cash plus inventory less trade creditors) which often happens to businesses that are expanding rapidly - purchases from suppliers have to be paid for before customers pay for sales made to them and if the business is growing, the amount of working capital required increases.
It is not advisable to defer remitting BAS statements and the associated GST payments as penalties and interest can be imposed and other sanctions too.
Depending on the exact circumstances, my advice to Susanne is to:
- Increase the amount of capital in the business to ensure it can continue trading properly:
- Share capital, either from herself or from other sources. Small companies can have up to 50 shareholders; and/ or
- Approach her bank to see about either a loan or an overdraft or extending any such facilities.
- Complete and pay the BAS forms as soon as possible
- When funds are available, pay outstanding creditors (taking advantage of normal credit terms from suppliers). Failure to do this may result in suppliers being unwilling to supply Susanne’s company any more which will, in due course, compound the cash flow problems
- Get further and ongoing financial advice.
Malcolm Simister, a Chartered Accountant, is an accomplished finance professional. He is a Practice Director at Parson Consulting, a firm specialising in assisting chief financial officers with their business performance management processes and business process reengineering.
The opinions expressed above are general in nature and are designed to help you to develop your judgement as a director. They are not a definitive legal ruling on the issue. Names and some circumstances have been changed to ensure anonymity.
Not for profit governance workshop – I’m presenting a seminar on building a strategic board at the Associations Forum Workshop in May.
The Audit Trail – I am a guest expert on this leading US blog. So far there have been four postings and they still keep asking me back!
Book review – Directors do a lot of reading. I keep a note of my thoughts on each book I read. Here is my review of 3 Dimensional Ethics by Attracta Lagan and Brian Moran.
This newsletter – I will issue The Director’s Dilemma monthly in 2008 then evaluate how it performed. If you have any ideas for improving the newsletter please let me know. If you would like to forward it to friends, please do. Ask them to subscribe on my website so they get their own copy in future.
Well, that is all for this month.
Enjoy governing your corporations; we are privileged to do what we do!
www.mclellan.com.au | PO Box 97 Killara NSW 2071
email email@example.com | phone +61 2 9499 8700 | mobile +61 411 262 470 | fax +61 2 9499 8711