How do you ensure that the numbers add up?

By Adam Bernstein, Monday 26 November 2018

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In God we trust, all others pay cash. It’s a famous saying first used by The Philadelphia Inquirer in 1877 and it makes a very valid point – how can a business ensure that it’s going to get paid?

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Without the benefit of a crystal ball it’s impossible to know; as recent examples of failing businesses have shown, past performance is no indicator of the future.

Delayed payments can be much harder to recover when the customer, or at least those in control of the business, operate via a corporate shell. Unless there are personal guarantees, or wrongful trading or fraud can be proved, the debts of the entity stand distinct from the assets of the individual. But in exchange for protection incorporated entities must put certain information, including company accounts into the public domain.

Defining company accounts

Peter Windatt, a director of BRI Business Recovery & Insolvency, notes that company accounts are simply a record of trading activity by an organisation; they’re a log of receipts and payments that are looked at to see if the business is making a profit. 

Windatt points out that a failure to keep proper books and records (suitable for the business being run) is an offence “which may lead a director to be in breach of all sorts of legislation and could even result in them being disqualified from being involved with a company in the future”.

In practical terms, the basics of accountancy are the same for all businesses. “Differences arise,” says Windatt, “when assets are acquired through different mechanisms such as by lease, contract hire, and lease purchase, and when assets are sold using different methods such as sale or return, consignment stock, sale and leaseback.” Each, he says, is treated differently for accounting purposes.

It’s for this reason, he explains that accounts carry weight “as they enable an informed user to form a view as to the performance of a company over a period of time through the profit and loss account, and to form a view as to its solvency at a given moment in time via a snapshot of the balance sheet which at its simplest lists of assets against liabilities.”

Looking for guidance

The problem with accounts, and it’s a point often missed, is that while they can help form an opinion, they are not required to look into the future. 

That said, Windatt explains that “detailed reports and accounts for a major PLC will differ greatly from a small one-man band as the disclosure requirements get more onerous the bigger a company becomes. For the average company there are no significant future-gazing requirements.” Accounts should be read with a pinch of salt and used in conjunction with other forms of checks such as credit information (see panel right).

And Stephen Diver, manager, Financial Reporting Advisory Group, Grant Thornton UK, agrees: “As statutory accounts only present historical financial performance caution must be applied when attempting to predict future performance.” He says that for listed companies there will also be forecast financial information, although it’s not audited. He adds: “It is possible to review trends within a set of accounts, as typically two years of information is disclosed, and previous statutory accounts may be downloaded from Companies House.” 

Another point Diver makes is that when assessing trends, it is important to read all information in the statutory accounts, for example a one-off event could lead to a significant profit or loss in a single period. This would not be indicative of future performance and should be disclosed in the directors report in the accounts.

As to what else the reader should be looking for, in broad terms, it will vary greatly with the nature of the business being considered. Says Windatt, “each type of company will have key performance indicators (KPI’s) and these will vary according to business type. Being able to analyse one company in a sector against others from the same sector is much more useful than comparing a company to all companies.” 

Even then he says that the way companies are funded is important because the reader may need to consider return on capital employed (ROCE) as well as earnings before interest, tax, depreciation and amortisation (EBITDA). 

“The further you dig,” says Windatt, “the more acronyms you will find and for each type of company and there will be key measures which will help you identify those whose performance is good from those whose performance is poor.”

Something else to consider, says Diver, “is that some accounts, such as abridged accounts, will not include a profit and loss account. As such, performance may be more difficult to assess for smaller companies.” He advises that an alternative is to calculate the movement in retained earnings between the two years disclosed, as in most instances this will equal the profit or loss for company. However, as other items may be included in this movement, it’s not an exact measure.

But fundamentally, as Windatt says, the adage turnover is vanity, profit is sanity and cash is reality is not too far from the truth – “anyone can sell product at a loss – profit is good on paper, but not a sign that you will survive if you can’t get the cash in from those who owe you.”

Understanding large creditor balances

Accounts can highlight large creditor balances. Where they exist a natural question to ask is: when do they become a problem for the debtor company? The answer appears to be: only when a large creditor believes it to be so. For other creditors the problem will only become apparent when there’s an action to wind up the company; any debts above a modest £750 and a company that hasn’t the cash to pay can be felled. 

Windatt thinks it unlikely for that sum, but it’s possible nonetheless, and he draws a distinction for a bankruptcy petition against an individual which is, by comparison, for sums above a loftier £5,000.

A legal definition of insolvency is found in S123 of the Insolvency Act – either assets are exceeded by liabilities, including contingent and prospective; and/or the company is unable to pay debts as and when they fall due. 

This means that it is easy to set up a company. The road to hell is paved with good intentions and most fail within a short period. As Windatt says, “a company that is on top of the world today may be in a very different place tomorrow, just look at the carnage on the high street and you will see that however grand the facade, a business can stand or fall within the blink of an eye”. 

Getting a feel for customers

Accounts are just part of the story as firms should know what type of business is being dealt with – a sole trader, partnership or some form of limited company.

Says Windatt: “Don’t be too re-assured that a firm says in its accounts that it is ‘Part of the XYZ Group’ because that only means it is a kite which, if it doesn’t fly as they might like, they can cut the string on and watch it fall with little damage to themselves.” He suggests that firms selling to this type of organisation should use a credit checking service, and if in any doubt about client payments, consider insuring the debt too.

While a printer might not think to look at its customers, it shouldn’t forget to also understand the financial health of its suppliers. Just as customers may not pay, production will cease if essential supplies aren’t available following supplier failure. Consider the position of a car manufacturer; they credit check their customers (dealers) for obvious reasons, but they also credit check suppliers so that one component cannot stop the line.

As to what should make an enquirer think when reading accounts, Windatt says to look for the obvious such as too many round figures. “Look for a sudden change in something – anything. See if debtor days are rising - they are selling but not getting paid; do the same for creditor days ditto - purchases are not being paid for. Also look for changes in the boardroom, remembering that some firms might not record changes at Companies House.”

To this Diver adds gross margins (profit) levels driven by cost savings; fully depreciated fixed assets that need replacing soon; loans that need repaying within 12 months and whether the business has the money to do so; and if there are any related parties that have loaned sums to the business or if any sales or costs are associated with them.

But there’s also the reasonableness test. As Windatt comments, we can all be wise after the event because hindsight is a great thing. He thinks printers should go with their gut – “when you are a reasonable person and expect others to act reasonably but can’t fathom out how or why they are acting in a particular way, you should have cause for concern.” While their motivations and drivers may be genuinely very different from yours, there may also be some form of undercurrent that could be harmful.

Diver believes that it’s important to look for “consistent losses, particularly if accompanied by a declining trend. An increase in liabilities may not be an issue if this is to fund for example capital expenditure but it’s likely to be a concern if funding losses.” In some cases, the directors’ report may provide some insight into the reasons for say losses or increases in liabilities.

A quick search on Companies House will show a variety of forms of company accounts – some long, some short. Should a short set of accounts be viewed with suspicion? Windatt thinks not: “If people are acting wrongly, they won’t file accounts or will make them up and wait for someone to catch up with them.” Remember, Companies House is just a repository of information, it doesn’t fact check.

Another tip from Windatt, and a saluatory lesson to boot - watch out for individuals retiring from a business. He cites an anonymised print example where “the former owners of a printer in Peterborough were still listed as directors at Companies House and guarantors to suppliers. They went on holiday after the sale of their company only to find on their return that the business was in ruins. The stock their [former] company had bought went to other businesses owned by the Northampton-based buyer. They were on the hook for everything.”

To conclude

With accounts it’s important to take a nuanced view as risk is a function of doing business on credit. Because of this Windatt says “do your homework, take as informed a view as you can, feel the fear, and then do what you think that is likely to be for the best. Have set credit limits and if you hit them – stop.”

Diver takes a different tack. He says that a company “may show a negative balance sheet, be insolvent on a balance sheet test, but not actually be in any financial difficulties, for example liabilities may include long term loans from group companies which will continue to support the company.” He also says that any a breakdown on liabilities trends in creditors can be useful, but they do need to be looked at in context of other movements. 


USE CREDIT INFORMATION

According to Ben Buckton, head of marketing at Experian, businesses ought to subscribe to credit information products to monitor client companies of interest.

A business credit report contains vast amounts of information, including credit information – existing business credit such as current accounts, loans and credit card information, along with balances and amounts outstanding; payment history - payment performance can offer real insight into a business’ financial standing and any potential problems they might be experiencing; County Court Judgments (CCJs) and bankruptcies - this indicates severe financial difficulties and may well act as a red flag; and Companies House records - with details on the directors, previous company names and annual returns.

Buckton says: “When a business applies for any type of credit, information on the credit report will be used, along with other sources of information, to determine whether they will lend.” He says that “a well-managed credit report will be seen by lenders as a positive, but businesses with little to no financial history – ‘thin file’ businesses – may struggle to be accepted or get the best rates.”

While credit information reports offer up detail on a firm, the information providers offer other services that include monitoring existing clients with automatic alerts - business performance can change and so can a business’ financial situation. This service helps spot any early warning signs; fraud avoidance - credit checking can confirm the identity of individuals and that their business is performing the way they say it is; and determining payment rates - understanding a prospect’s previous payment behaviour and their credit history will help adjust credit terms.

Allied to this, Buckton says that credit information can be used to see a subscriber’s own profile: “Without full sight of your own company’s credit score, you don’t know how others see your business. As a result, you may have to accept lower credit terms. You can even be denied credit.” In other words, it can be used to understand and then enhance a company’s own standing.

As to the typical costs, they vary from provider to provider and on level of information sought. As an example, Buckton says that Experian offers Business Express which looks at companies of interest from £25 per month. It also offers My Business Profile for £25 per month to those that want to how their own business is seen by third parties.

It’s worth pointing out that there are other companies that provide credit information, including ICSM (www.icsmcredit.com), which specialises in the print sector.


THE WARNING SIGNS

Peter Windatt says firms should check for warning signs, when checking either a supplier or customer, looking for any one (or multiples) of the following:

Round sum payments that are made by the company

Late payment to employees (which may end up as claims in the Employment Tribunals)

Reduction in visible sales revenue

Information not forthcoming upon request and/or management avoiding issues raised

Accounts not filed at Companies House as well as annual returns not filed or filed late

Any general negative publicity

High staff turnover – adverts for vacancies – which could indicate employee dissatisfaction

Sector information – material that appears in the public domain, for example the trade press

Website and social media information – might be based on gossip, but could be grounded in fact

Local intelligence and customer experience

An autocratic organisation where the roles of chairman and chief executive are combined

Ineffective board where behaviour and denials of problems are apparent

Owners and directors actually working in the business, not on it – firefighting in other words

Information flow that has broken down

KPIs that are unknown and/or falling

Neglect of core/day-to-day work in favour of a big project that is utilising all resources

Concentrations of customer where the business effectively has all of its eggs in just a few baskets

Focus of the business is misguided in that it’s driven by sales and not profit

Working solutions

Firms should institute a traffic light approach to combat negative information from accounts or otherwise.

Green Go ahead but keep under review. Here a single ‘big’ issue could cause failure

There are some breaches of terms, but supplies continue

The firm appears able to pay bills including current tax; arrears being scheduled

Amber Proceed but with caution. Any issue could cause failure

The company has accounts on stop with some suppliers and is paying pro-forma

New credit on normal terms is unlikely to be granted

New orders are not being accepted due to overtrading

Legal action is being threatened

Red Urgent professional input required. Failure is likely

Take action if it becomes known that the business is on stop with key suppliers

Also consider action if the firm cannot raise working capital or if income doesn’t meet outgoings

Legal processes in train and CCJs being registered are a clear sign of serious distress

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