Crisis Management and Solvency

As the health crisis and economic crisis meander into May and talk of business reopening and restrictions relaxing in some states, Boards will have to continuously interrogate their finance team to satisfy themselves in terms of present and future solvency, stress testing and mitigation and management of elevated global and market risk. In times of general crisis, the leadership of the board is crucial in steering business to calmer waters. Supporting management and guiding them is a key fiduciary duty of the Board. A hands off approach simply won't cut it.

As an advisor to boards faced with unprecedented uncertainty, we have been doing lots of talking and thinking about how best to manage prudently without unneccessarily causing distress and panic. There are a multitude of ratios, questions, warning signs and expectations that can be planned ahead of crisis to help in the heat of the moment as it descends upon you.

Solvency is also a fairly critical board responsibility both under the regulator and the stakeholder expectation areas. You don't have to be a qualified accountant to ask really good questions of management. Questions like, "Do we really know when debts are legally due?" So often we see budgets set annually without a reforecast with scant attention to timing. We also often see overheads left for years at a time without line by line scrutiny of what can be deferred well ahead of time, what conversations need to be had by management and what contracts can be renegotiated. Breaking your cost structure into the "must haves" and the "nice to haves" is a critical step in finding cost efficiency when top line revenue is impacted.

Do you get regular and accurate cash flow projections at board meetings? There is an old saying that Balance Sheets are vanity as they are often largely based on subjective valuations. Profit and Loss or Income statements are sanity as they tell the story of whether the business is profitable in it's undertaking but in times of crisis, cash is king. Selling goods on credit is only useful if you ultimately collect the cash! Bad debts and slow paying debtors are the killer of many a profitable business.

Is there support at the Bank if we have a short term cash crunch? Has this question even been asked? Often we see the topic avoided until it can be avoided no more. There is an overtone of being embarrassed or of having somehow failed that prevents some management groups from wanting to broach this topic without a gentle nudge. Far better to have the conversation six months out and have a banker disappointed than it is to have them surprised and on the back foot. Respect that the banker also has to go through a process, a very much more convoluted process post royal commission to get liquidity through credit in the bank. Give them as much time as possible to help them help you. Rest assured, we are all in this together.

Next - have a really good look at the Balance Sheet provided to you. Are their assets listed that are no longer what they are listed at? Should the Balance sheet be adjusted to give a true picture of current valuations at a realistic level? Even better, are there assets listed that are not really required by the business that could be earmarked for sale should conditions demand a liquidity event. Can this be quarantined or acted on early so it isn't at maximum stress levels. Are assets listed in the right spots and why does this matter? Ratio analysis demands that current assets and current liabilities only include items that are going to eventuate in the next 12 months. If longer than that, they should be moved to non current. Should liabilities in particular be looked at to ascertain both principal and interest commitments to show real cash obligations, not just the interest. If holding stock, what does the aging report look like? Has the number of days started to drift out? If not, good, if so, are the items still saleable or not. Writing back early prevents relying on things that won't sell later.

Same with receivables (Debtors). Have the days started to drift? What is the process for collection? Has it changed since the pandemic? If not, does it need to? All good director level questions for management and for management to be thinking about in terms of achieving their key performance indicators (KPI's).

With capital expenditure, dividend policy and management of income tax, have we got a multi year plan? If so, are there items that can be deferred to another period to preserve cash flow? I put these items together as they are essentially the choice points post making a profit to balance what is reinvested in the business, managing taxation and managing shareholder expectations in a company setting. In a family setting it is less formal but realistically the same choice points.

We have seen the big banks in recent days hold back a dividend in full. I would expect big business to make more of these types of decisions over the coming six to twelve months. In property, there will be similar decisions being made in relation to commercial rent "holidays" or deferrals, residential rent restrictions on eviction as the whole economy adjusts to broad based unemployment and underemployment. Those on reduced hours are the hidden statistics in this whole thing. It would appear it will only get worse before it gets better.

Finally, Boards need to consider the uncomfortable ground of whether the business is and is going to continue to be viable. For those going through this very difficult ground, it is useful to get advice from professional advisors. The insolvency practitioner field are very generous with initial discussions around confronting the brutal facts and the gamut of actions open to Boards and management. My professional experience is that businesses rarely regret discussions of this nature, more often they regret not having done it sooner even if ultimately (hopefully) it is not required.

Finally, a good exercise to do for any business is to complete an Altman's Z-score. This is a model that predicts the likelihood of insolvency based on five performance ratios combined into a single score. The formula sounds like something out of "a beautiful mind" but is actually pretty simple to follow. it is merely expressed as Z-Score equal to (1.2A + 1.4B + 3.3C + 0.6D + 1.3E). where A = working capital divided by total assets

B = retained profits divided by total assets

C = EBIT (earnings before interest and tax that is the real underlying operating profit) divided by total assets

D = market value of equity divided by total liabilities

E = sales divided by total assets.

The lower the value, the higher the probability the organisation is headed for insolvency. Below 1.8 you are likely headed for insolvency. Above 3 you are safe. Between 1.8 and 3 there should be further scrutiny to ensure you don't go below 1.8. Is this a metric you should be demanding from your CFO for your next meeting as part of prudent financial risk management? In addition, should budgets being prepared over the next month be stress tested using this as a metric to test what could and should be done before signing off on the financial control budget this time round.