Companies fail for a variety of reasons. Sometimes it is due to one large instance, but most often it’s an aggregate of small decisions, or inaction, that leads to insolvency.
Generally speaking there are three common scenarios that frequently lead to insolvency, and inevitably liquidation:
- Black Swan events
- Pervasive operational losses
- Mismanagement
Black swan events
Sometimes things happen which are unforeseeable and out of our control. This is a common occurrence especially in the construction industry.
Example: A construction company has one project with one developer. The construction company submits a payment claim for work done every month. The developer will undertake an assessment of this work and issue a payment schedule for the amount they believe to be payable.
For every month of work the construction company needs to pay it’s subcontractors, suppliers and overheads. If the developer assesses the work far less than the claim, it will leave a working capital deficit which needs to be addressed.
It can quickly become an existential issue if subcontractors refuse to work and suppliers place the company on stop credit. This effectively means it will need to introduce fresh capital to continue to trade.
If additional capital can’t be introduced, the construction company may have to consider liquidation.
Consistent monthly losses
Another common scenario is where a company constantly underperforms for an extended period of time.
This is commonly encountered in retail and hospitality, and sometimes construction.
A typical example is a retail outlet that operates a number of outlets. Most of the outlets are profitable or at break-even while one outlet constantly makes a loss.
Although there might be a good argument for keeping the unprofitable store open, the reality is over time the losses accumulate putting the entire business at risk of insolvency. This is a typical and common example where inaction and lack of early intervention causes a company to fail.
Mismanagement
Mismanagement of a company can take many forms, some quite extreme and deliberate, while in other instances good-intentioned yet negligent.
Examples of extreme mismanagement:
- Directors taking excessive drawings, or purchasing luxury items instead of paying creditors
- Directors being ‘on the tools’ and not paying attention to the administrative side of the business. In some cases not maintaining financial records at all.
The above examples lead to situations where the true financial position of the company is unknown, the company is inefficient and disorganised, and capital that should have gone to creditors goes to drawings.
More subtle and even well intentioned examples of mismanagement include:
- Directors not proactively making staff redundant when work demand is lower than expected
- Directors not adequately diversifying revenue and having the proverbial eggs all in one basket.
While good-intentioned or naive, excessive expenses and inadequate diversification of revenue can lead to insolvency and places staff and creditors of the company at risk.
