Whether the predicted global recession reaches Australia or not, small business insolvencies and payment defaults have risen recently.

According to Equifax, SME insolvencies have increased over the past two years. This has happened more sharply in 2022, with 20% more insolvencies in June this year vs the same month in 2021. However, it’s worth pointing out that current insolvency levels are lower than those of 2019, immediately pre-COVID.

At the annual SME Big Breakfast in Melbourne recently, Banjo and CreditorWatch gave a joint presentation about how businesses can protect themselves from insolvency. The level of interest and discussion showed that this is currently a very hot topic. Here are some of the insights from that session.

CreditorWatch’s Business Risk Index (BRI) August 2022 data continues to show a clear trend of growing defaults in B2B trade payments. As the BRI data is mostly sourced from small and medium businesses, the signs give some cause for concern. According to CreditorWatch, among the pressures on SMEs are a 4.6 per cent increase in labour costs, and purchase costs up by 5.4 per cent. While businesses can pass these increases on to consumers at this stage, with overall product prices increasing by 2.7 per cent and retail prices by 3.3 per cent, how long this will prevail, is not clear.

According to CreditorWatch’s Geographic Business Risk Index, the areas currently experiencing greatest risk of SME default or insolvency are parts of Western Sydney (Canterbury, Green Valley, Merrylands), Jimboomba in south west Brisbane, and Surfer’s Paradise. More broadly around the nation, the industries most impacted are food and beverage, followed by arts and recreation.

What is insolvency?

A company is regarded as insolvent (from an accounting perspective) when it can’t pay its bills as they fall due, and when its liabilities are more than its assets. Among the factors that could push a business over the edge are: poor cash flow management, over-expenditure, or scarcity of staff.

Equifax points to an unfortunate reality that when a business is financially distressed, too often those running it resort to doing the wrong thing. Corporate liquidators report that 71% of all reported misconduct involved breaches of insolvent trading conditions. This being, despite signs being evident the companies in question were insolvent or becoming insolvent. It goes without saying that this only leads to more complex problems for the business, not to mention being illegal. Being alert to warning signs and taking appropriate steps to manage the situation can help avoid disasters.

The warning signs

During an economic slowdown, even well-run businesses can begin to struggle. For example, if a supplier of hard-to-get materials or one of your key customers becomes insolvent, this can have a knock-on effect on your business, through no fault of your own.
To protect your business, it’s critical that you’re willing to confront reality, and take responsible steps to mitigate the situation.

The red flags that could indicate your business is in trouble include:

  • a recent history of working capital shortfalls, unprofitable trading and/or deteriorating cash flow
  • difficulty paying amounts by due dates, including statutory debts (e.g. PAYGW, SCG, GST), or dishonouring payments
  • having an overdraft or other finance facility at the limit
  • debt to equity ratio below 30%
  • sustained decline in profitability
  • struggling to collect debts, high amount of overdue payments.

Even if your business is going well, with no specific danger signs, there is the potential for greater contagion risk in this period of economic uncertainty. For example, one of your clients may be having difficulty getting payments from their customers, which could result in an inability to pay, or to supply to you. Keep a close eye on your network of suppliers and customers, and keep in touch with them. As far as possible, understand the nature of any financial risks facing their business which could indirectly impact yours.

Protecting your business from insolvency

Some of the steps you can take to protect your business include:

  1. Keep a close eye on your business’ working capital and ‘cash conversion’ cycle (CCC), which is the average number of days it takes to purchase inventory and then convert it to cash. If you’re currently experiencing a high CCC, but your customers are solid, consider a working capital loan to help cover the cycle.
  2. Fine-tune the timing of your payments to optimise the outcomes. While it can be tempting to delay payment to suppliers to preserve your own cash flow, this ultimately impacts your business reputation, your credit rating, and pushes the cashflow issue onto your supplier.
  3. Invoice at the earliest opportunity, such as immediately the work is completed, or the product is shipped. Make it easy for people to pay you, by having a simple online process.
  4. Have a clear and effective credit control process, to help you identify any exposure at an early stage and take the appropriate action. Keep a close eye on customer credit limits and be wary of extending them.
  5. Ensure you have a quality accounting package and leverage a quality debtor collection system or process.
  6. Manage your inventory (if applicable) carefully. Set limits and budgets and stick to them.
  7. If you need short term funds to respond to a business opportunity that will help your business grow and secure its future, look at options like Banjo Loans’ working capital loan where fast approvals ensure you can move forward without delay.
  8. Talk to your advisers (accountant, lender, broker) sooner rather than later, to appraise them of your situation and help you work on strategies to avoid insolvency or default.

With business sentiment still relatively positive, consumer demand remaining high, and supply chain issues finally resolving, hopefully Australia will navigate around the recession storms.