Directors: Watch Your Liquidity and Solvency
‘How did you go bankrupt?’ Bill asked.
‘Two ways’ Mike said. ‘Gradually and then suddenly.’
(Ernest Hemingway “The Sun also Rises”)
Nothing is more demoralising than running into financial difficulties. Suddenly all your energies are focussed on survival rather than growing the business. The fun goes out of the organisation, rumours of retrenchment flourish and if management aren’t careful, the rumours can become self-fulfilling.
The importance of liquidity and solvency ratios
Since the “new” Companies Act came into force, there has been a change of emphasis. The “old” Act considered the cornerstone of sustainability to be “capital adequacy” – acceptability amounted to your equity being positive (share capital plus retained profits).
Globalisation and technology have speeded up business cycles and have shifted modern thinking to liquidity and solvency as determinates of a company’s viability. The new Companies Act adopted this philosophy.
What are liquidity and solvency?
Liquidity measures the organisation’s ability to meet its short term liabilities over the next twelve months i.e. paying all creditors and any debt that is due in that period.
Solvency measures whether an organisation’s assets are greater than its liabilities over the next twelve months. If your liabilities exceed your assets then you usually have taken on too much debt or you are trading at a loss.
There are ratios that you can use to determine liquidity and solvency, but probably the best approach is a detailed cash flow that looks to at least the next twelve months – but usually for longer periods depending on how much confidence you place on the reasonable accuracy of the cash flows.
Part of the cash flow process is to consider all known risks and to measure the potential impact they will have on cash flow if the risks materialise. In this way you can plan for any contingencies and how you will respond to them. You can, for example, keep cash reserves to cover potential risks occurring.
Many best practice businesses do cash flows as part of their monthly financial procedures.
If the cash flows or ratios show the business is getting into cash difficulties, then you have time to react.
This time is crucial as it is the difference between controlling the process or being controlled by it.
What the Act requires, and the risk of personal liability
In terms of the Companies Act, if it is likely that the company will not be able to meet its short term liabilities or will become insolvent in the subsequent six months, then the organisation needs to consider:
- Going into insolvency if the situation is unsalvageable, or
- Commencing business rescue proceedings.
Remember that directors risk personal liability if they could have foreseen financial losses but fail to initiate business rescue proceedings or declare bankruptcy.
The bottom line – be prudent
Keep yourself informed and ensure that you are checking that liquidity and solvency tests are being performed. Ask your accountant for advice at the first sign of trouble!
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