Business Solution

5 Alarmingly Common Reasons Stable Businesses Become Insolvent

  • AUTHOR: Ivan Lavelle
  • DATE: 03/10/2015

Is your business at risk of becoming insolvent?

Could the loss of an important staff member affect your business’s ability to continue trading?

Could the loss of an important staff member affect your business’s ability to continue trading?

Has your business run out of cash? Businesses can often run for years before a cash flow problem suddenly emerges, leaving you unable to pay staff, suppliers and other creditors essential to your business’s continued operations.

If your business is generating a steady profit every month, it can be very tempting to assume that nothing could possibly go wrong and threaten its financial stability and solvency.

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Businesses fail for a wide range of reasons. Sometimes, competition slowly erodes a business’s hold over its market, reducing its profits. In other cases, businesses fail in a rapid, surprising fall that catches everyone – including the director – off guard.

Insolvency can often occur suddenly, leaving your business in a difficult position and forcing you to consider options such as administration or liquidation. Even “sudden” insolvency, however, is often the result of long-term problems in your business.

We recently spoke to Corporate Recovery Help to learn more about why businesses become insolvent so rapidly. They shares five alarmingly common reasons for rapid business failure, as well as ways to mitigate the risks of each cause of insolvency.

#1 – Lack of proper long-term cash flow planning

There’s an immense amount of truth in the expression “cash is king”. Businesses that have sufficient cash to continue operating through the loss of a large account or new competition have time on their side thanks to their cash reserves.

On the other hand, businesses that keep very little cash in reserve and spend almost all of what they earn on salaries, assets and other investments can be damaged by a problem that, for a more financially healthy business, wouldn’t be an issue.

One of the most common reasons profitable businesses become insolvent is because their management, after seeing one profitable quarter after another, assumes that it isn’t unsafe to reduce the amount of cash the business has in its accounts.

This doesn’t always take the form of large bonuses or salaries – two common clichés of the business world. Companies often spend their cash on hard assets that, while a good investment in the long term, don’t produce immediate cash flow.

When a cash flow crisis hits, they’re left without enough cash to weather the storm, leaving them insolvent and incapable of taking action. This issue affects both small and large businesses that fail to adequately plan ahead for the long term.

If your business is enjoying a particularly good quarter, it’s important not to let it convince you that there will always be large amounts of cash coming in. When you plan for a crisis and keep cash in reserve, you’ll be better prepared and protected.

#2 – Loss or failure of an important customer

Winning the business of a large customer can feel great, especially if you’re the sales representative responsible for closing the deal. But if your business becomes overly dependent on one customer, it can leave it seriously at risk of becoming insolvent.

This might seem illogical – after all, how could earning more money mean that your business is more likely to become insolvent? The issue isn’t increased revenue, but an increased dependence on a single source of revenue that’s potentially fragile.

If your business needs to expand to deal with the demands of a large customer – for example, by hiring addition staff to service their account – it also needs to increase the amount of cash it spends every month.

Lose the customer and your business loses its source of income while retaining all of the costs that came with the contract. Often, you don’t need to “lose” their business – if the customer runs into financial difficulties, they may be unable to pay you.

It’s important for your business, whether small or large, to have a diverse range of customers. If your business is currently largely dependent on one customer, focus on acquiring new accounts to diversify its income and reduce its insolvency risk.

#3 – Excessive borrowing to fuel business growth

Credit can be a fantastic tool for expanding your business. When used intelligently, a line of credit lets your company buy advertising, invest in essential equipment, hire staff and put in place an efficient system for generating profits every month.

However, borrowing comes at a cost. When your business grows based on credit, its debts increase, meaning that it will eventually have to pay back a significant amount to its creditors.

Combine excessive borrowing with the two problems described above – poor long-term cash management and dependence on one customer – and your business could find itself in an impossible financial position if it loses an essential source of income.

Lots of businesses depend on credit to a certain extent, and not borrowing anything at all could ultimately hurt your business’s ability to grow. However, reckless credit usage can slowly creep up on your business and cause serious damage in the future.

If you’re borrowing money to help your business grow, make sure you plan ahead of time to ensure that not only are you capable of repaying loans if things go according to plan, but that you’re also able to repay loans if things don’t turn out perfectly.

#4 – Risky, unreliable business strategy or investments

Some of the most profitable businesses – at least in the short term – depend on very risky, speculative business models. With risk comes reward, and risky investments can produce huge profits when the market moves in the right direction.

When it moves in the wrong direction, however, making risky investments can hurt your business. Speculative investments, whether in property or shares, often lead to potentially massive losses for businesses that were previously profitable.

The financial crisis of 2008 revealed the weaknesses of risky business models to a large audience, but many businesses still continue to bet on gambles in the hope of increasing short-term earnings.

If your business is producing large profits using a risky business model – one that’s heavily dependent on short-term opportunity or volatile market, for example – it’s worth examining its potential to fail if market conditions changed.

#5 – Loss of a staff member integral to business success

Just like depending on one or two customers to fuel your business’s revenue can be a risky strategy, depending on one or two key members of staff to run your business puts it at risk of failure if those staff members decide to leave.

Highly competent employees are worth a lot, not just to your business, but also to its competitors. If a staff member is producing great results for your business, there’s a chance they’ll be approached by a competitor and offered a more lucrative job.

There are also staff-related factors outside your control that could affect your ability to retain key staff. If an important staff member suffers from health issues, there’s a possibility that they might need to leave your business on relatively short notice.

If either of the above situations affects your business’s ability to operate, it’s overly dependent on key staff members. Effective businesses depend on their staff, but not to the extent that the departure of one or two people destroys the business itself.

If your business is overly dependent on a few key individuals, it’s important that you take steps to spread the responsibility of operating your business between members of staff so that a sudden departure doesn’t seriously damage your business.

  ABOUT THE AUTHOR:
Ivan Lavelle
Ivan Lavelle

Ivan Lavelle is a company finance expert from Corporate Recovery Help, insolvency consultants specialising in company voluntary arrangements and pre-pack administration.

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