WHAT YOU NEED TO KNOW

Before embarking on a turnaround, it is vital to investigate your current financial position. You need to consider the following questions:

• How did I get here? What has the recent trading performance been like and what are the trends?
• Where am I now? Are you insolvent or not? What cash do you require in the short term? To what degree can you rely on the bank for support?
• Where am I going? What are the longer-term cash, profit and loss, balance sheet and security forecasts?

If you are in a cash crisis, you have to focus on the second point before addressing the past or future so as to ensure your immediate or short-term survival.

Understanding your past financial performance is covered in Chapter 7. Short-term forecasts (which you need to prepare to obtain the proper advice on continuing to trade and to assess the immediate cash requirements and the likelihood of bank support) can be rolled forward later for use in longer-term planning.

All the workings and examples in this chapter assume you are a director of:

• a limited liability company incorporated in England and Wales
• with a number of employees
• that is registered for VAT and
• has an overdraft for which the bank has taken security by way of a valid standard UK bank debenture covering any debt due (an ‘all-monies charge’).

The key questions in a cash crisis are as follows:

• 1.Is the company insolvent? If it is, whilst you do not necessarily have to cease trading, there are potential implications and risks of personal liability for the directors (and shadow directors) that can arise out of your legal duties and on which you need to obtain advice (see Chapter 11).
• 2.Does the company have sufficient cash for the immediate/foreseeable future? If not, you have just answered question 1.
• 3.Will the bank (assuming the company has bank borrowings, e.g. an overdraft) continue to support you? This may well determine the answer to question 2.

INSOLVENCY

In principle, insolvency simply means the company is unable to pay its debts as they fall due. Where a winding-up is sought on these grounds, the Insolvency Act 1986 sets out four tests, failure of any of which is taken to prove insolvency:

• 1.Failure to deal with a statutory demand.
• 2.Failure to pay a judgement debt.
• 3.The court is satisfied the company is failing to pay its debts where due (‘the cashflow test’).
• 4.The court is satisfied the company’s liabilities (including contingent and prospective ones) are greater than its assets (‘the balance sheet test’).

Therefore both the short-term cashflow forecast and the revised balance sheet used to check the security position (covered in this chapter) are the tools you need to check the last two tests.

Insolvency matters because, if the company fails, a liquidator can potentially act to set aside some transactions made when the company was insolvent and hold you personally liable for the company’s losses (see Chapter 11). Additionally, your responsibility for the insolvency will be taken into account when considering company director disqualification proceedings (see Chapter 11). If you are not trading through a company but are acting as a sole trader, however, you have unlimited liability for all your own debts (business and personal). If you are trading in a partnership, all the partners are liable together and individually for the partnership’s business liabilities (’jointly and severally’) unless it is a Limited Liability Partnership (’LLP’). The moral is, when in doubt, if you are concerned about solvency, you should seek professional advice.

Example

Companies D and E’s balance sheets with assets stated at book value are set out below:

	Company D	Company
	(£000)	(£000)
Property	500	500
Debtors	100	100
Stock	50	50
Cash	0	0
Trade creditors	(850)	(350)
Net assets	(200)	300

No overdraft facilities have been negotiated.

Company D is clearly insolvent on a balance sheet test in that its liabilities exceed its assets. Worse still, in winding up a company, the ‘going concern’ basis of accounting no longer applies. This means that:

• Assets will be restated at realisable values (i.e. what they can realistically be sold for) rather than at their normal book values. Where property has been carried in the books at its cost 25 years ago, this can be good news. More often, however, it means bad news in respect of debts, stock and work in progress, which have to be written down as what will actually be recovered.
• Liabilities must include contingent liabilities (e.g. redundancy payments to employees) that will fall due for payment (‘crystallise’) on failure of the company and are therefore generally higher than shown in the books.

When it comes to preparing an insolvency statement of affairs, Company D may therefore find its position is worse than it looks here on book values.

If all Company E’s trade creditors are now due for payment it is insolvent on a cashflow basis as it does not have the cash to hand with which to pay these debts. Whilst it has surplus assets, its cash is largely tied up in property – an illiquid asset.

CASHFLOW FORECASTING

To assess whether you have sufficient cash for the immediate and/or foreseeable future, you need a cashflow forecast. At this stage you usually need to concentrate on the short term and prepare a forecast on a weekly basis for the next 13 weeks but, in extreme cases, you may need to prepare one on a daily basis, covering only the next few weeks.

The cashflow forecast is a vital document for the following reasons:

• It can be used to actively manage the cash to ensure survival (see Chapter 6).
• It will help you to obtain proper advice as to whether to continue to trade or not (and so protect your personal position).
• It will help in obtaining and maintaining bank support.

Cashflow forecasting is essentially straightforward as you are dealing with real cash movements into and out of the company, not abstract ‘accounting’ transactions, such as accruals, prepayments or depreciation.

For a weekly forecast, all you are looking to calculate are:

• the cash you are going to get in that week
• less the cash you are going to pay out that week
• to give a net movement (‘flow’) of cash into or out of your company.

Adding the net inflow (or deducting the net outflow) of cash to the balance held at the start of the week gives the balance at the end of the week, as shown below:

An example of a cashflow forecast for Company F is shown in Figure 10. This type of forecast can be set up on a spreadsheet or filled out manually, and the headings shown should be sufficient to cover the main receipts and payments of most companies.

The secret to cashflow forecasting is to keep it simple and to work methodically and logically down the page through all the cash coming in and going out of the business. For example, cash received will come from the following sources:

• Existing debtors, who pay during the period. Look down your list of debtors, decide who is likely to pay in which week and fill in the boxes.
• New sales for cash. Prepare a simple weekly sales forecast by branch, line of business, contract, customer or whatever is most appropriate. Then calculate how much of these sales will be for cash (in Company F’s case, 40%) and fill in the boxes (remembering to add VAT as your receipts will be gross).
• New sales on credit, where the customer pays within the forecast period. Once you have forecast sales, those that are not for cash must be made on credit. How long a credit period are you allowing your customers, and how long are they really taking to pay? For Company F it is broadly two weeks. Use this as a guide to plotting the likely weekly receipts from these new sales (again gross of VAT).
• Any other sources. Will you be selling any assets, injecting any new funds, receiving any insurance payouts, like Company F, or generating any other cash from anywhere at all? If so, estimate how much and in which week (don’t forget VAT where it applies), and enter the figures.

You can now total all these to obtain your estimated total weekly inflows. Outflows are calculated on exactly the same principles. Do you pay the wages weekly or monthly? Write in the net amounts when they will go out. PAYE is due once a month, VAT at the end of the month following the end of the quarter, so predicting the dates of these payments should be straightforward.

Your purchase ledger/trade creditor list also tells you whom you owe money to for purchases. So in the same way you forecast receipts from debtors, go down the list and plan when you are going to pay what to whom. Bear in mind you will also need to continue to make purchases as you trade, so forecast these in the same way as you forecast sales and plan in the payments (gross of VAT) for when you are going to make them.

You will need to plan payments for rent, heating, lighting, power, telephone and your other commitments in the same way, as well as remembering to estimate how much VAT will need to be paid, and when.

The keys to successful cashflow forecasting are:

Know where you are starting from

As you stand today you have a balance at the bank; you are owed money by your debtors you are expecting to receive; and you will owe money to trade creditors, the Inland Revenue, HM Customs & Excise and so on. Use these figures as your opening balances. If you do not have exact figures (why not?) use your best estimates.

Make sure you are consistent

Try to forecast the balance that will be shown on your bank statement rather than that which will show in your cashbook, as this will give you the most useful information. Enter the current balance from your bank statement as your starting bank balance and add back all those cheques sitting in the drawer or unpresented to your opening creditor figure so as to show how much you really owe.

Be realistic in your estimates of timings and amounts

Your forecast needs to take into account the following:

• What level are sales/purchases running at now?
• What changes are really likely to happen over the period?
• What have you experienced in prior periods? (How quickly do your customers actually pay?)
• What are your terms of trade? (What length of credit do you allow customers/are you allowed by suppliers?)
• What are your due dates for statutory payments? (For example, the 19th of the month for PAYE.)
• What are your periodic payments? (For example, quarterly bills for utilities and rent.)
• What capital expenditure are you planning?

When in doubt be prudent

Be pessimistic about when and how much people are going to pay you, and about when you are going to have to pay others.

Make your assumptions explicit

If you tell your bank manager sales are going to increase by 20% the week after next, you can then also tell him or her this is because your contract with XYZ plc comes on stream. Otherwise the manager may just think you are relying on the ‘new sales fairy’ to wave a wand and make this happen.

Check that you are showing all aspects of any transaction

Company F has taken on a new sales representative for branch 2 (wages and PAYE go up). It is buying a new van for this representative (a deposit is shown as capital expenditure and a new monthly HP charge), which will require fuel (motor vehicle expenses). Of course the reason for doing so is to increase sales and hence debtor receipts, but these will also be reflected in increased purchases and, hence, payments for goods sold.

Experiment with sensitivities

Flex some of your key assumptions (what if sales go up by 5% instead of 10%; what if customers take 60 days to pay instead of 45?) to see how sensitive the forecast is to these fluctuations. Make sure you reflect fully all aspects of any change, however. But remember the above point: if sales go down, purchases should fall as well.

Think widely

Check you have allowed for all possible payments that may need to be made by comparing the type of items with last year’s detailed profit and loss account. Have you allowed for corporation tax, redundancy payments, pension top-ups or repairs if any of these are likely to fall due in the period?

Turnarounds tend to require professional assistance. Have you allowed sufficient to cover the accountants, lawyers and bankers’ fees? Go through some old bank statements and cheque-book stubs. Have you allowed for all types of payment you find?

Check carefully to make sure it all adds up

Company F’s cashflow forecast has ‘check totals’ built in at the end. These are simply sums that add up the elements of the forecast in different ways to ensure nothing has been left out. An example of the principle is illustrated in Figure 11, where the first 9 is calculated by adding together the values of all the column totals. The second 9 is calculated by adding all the row totals. If the two check sum totals match, you can be confident there are unlikely to be any basic arithmetic errors in the forecast.

Build in margins for errors

Build in a margin as a round sum contingency to allow for the things that will inevitably come crawling out of the woodwork. The more uncertain your starting point, the larger this needs to be, up to, say, 10% or 20% of payments in some cases.

Part of the reason for cashflow forecasting is to build the bank’s confidence you are in control of your finances. Having a contingency in place is not only prudent, but if it helps ensure you beat your forecast cash performance, it will also help to ensure the bank’s confidence in your management skills will increase.

Example

The technique can also be used to review any large contract or project a company is planning to undertake. Company G is a roofing business at the limits of its overdraft and it receives news it has won a large contract, the details of which are as follows:

Contract value	#£620K
Subcontracted labour	£300K at £50K per month over six months
Materials	£200K, of which £100K is required in the first month, followed by £20K per month for five months
Giving a profit of	£120K

Whilst the company has one month’s credit from its suppliers for materials, it has to pay labour monthly (but labour is paid gross with no PAYE deductions). There is no retention on the contract and the company is to bill at the end of each month for the materials delivered, labour and one sixth of the profit, and the client will pay at the end of 30 days. The directors are jubilant and are convinced this is going to save the company. Undoubtedly, it is a profitable contract. But should the company take it? The answer lies in looking at the cashflow (to simplify matters, VAT has been omitted):

Projected project cashflow (£ 000) per month

	1	2	3	4	5	6	7	8
Receipts	—	—	170	90	90	90	90	90
Payments
Labour	50	50	50	50	50	50	—	—
Materials	—	100	20	20	20	20	20	—
Total payments	50	150	70	70	70	70	20
Net movement (out)/inflow	(50)	(150)	100	20	20	20	70	90
Cumulative	(50)	(200)	(100)	(80)	(60)	(40)	30	120

The answer, then, is clearly no – not as it stands. The project’s early cash outflows mean the company, which is at the edge of its facility, will immediately run out of cash if it accepts the contract and starts work.

Instead, Company G must explore whether the proposed payment terms can be changed to speed up receipt of cash (e.g. an upfront payment), whether greater credit can be obtained from the labour and material suppliers and/or whether it can negotiate increased facilities with the bank to enable the project to be undertaken.

Once you have prepared your forecast, use what you have produced.

Review it critically

Having prepared your forecast on a prudent basis, now see what scope there is for moving payments or for bringing forward receipts. Compare the balance at the end of each week with the facility you have with the bank. Do you have ‘headroom’ or are you going to be in ‘excess’?

Use your forecast to plan

If you are going to be in excess, plan what you are going to do about it (see Chapter 6). Look at what payments or receipts you can change and/or speak to the bank in advance about the excess to agree a temporary extra facility. Use the cashflow forecast to explain why the excess will occur, how much it will be, how long it will be for and to explain how you are going to reduce your borrowing to return to your normal facility.

As a word of caution, however, don’t run to the bank with your first draft cashflow forecast as this is likely to show a dreadful cash position (you have been pessimistic after all). Only discuss your forecast with your bank once you have had a chance to review it thoroughly to amend and adjust it for the things you are realistically going to be able to manage to improve the position. You need to discuss a final working forecast that is challenging but realistic and prudent, not ultrapessimistic.

Use your forecast to monitor

Roll the forecast forwards, week after week, comparing what actually happens to your forecast. Ask yourself where they differed and why. Then ask what that tells you about your estimates going forward and where you can/should amend your forecast to improve your estimates. From Company F’s actual results in weeks 1-3, it seems the contingency built in is too high as the only sundry expense has been the milkman at £15!

SUPPORT FROM THE BANK

Banks tend to support customers in difficulties when the following conditions are met:

• The bank trusts your integrity.
• You talk to the bank in time (and seem likely to continue to talk to them).
• You seem to be in control of your business (and its numbers).
• You have a plan.
• The plan sets out clearly what support you need (how much, how long, how it is to be paid back).
• You are prepared to get in help where you need it.
• The bank is confident your plan can work.
• The bank is confident you can make it happen.
• Your plan does not materially increase the bank’s risk.

However, you need to understand the bank’s perspective. If you were a banker, whom would you be prepared to lend money to? Essentially the answer is: someone you were confident was likely to repay you. After all, it takes a great deal of interest income from loans at 2% over the cost to the bank of borrowing the money to claw back a lost loan. But what makes a bank confident that its loans to a company are going to be repaid?

The bank has to judge its confidence in your ability to use that money sensibly and to control your business. If your business needs a turnaround, particularly when it has reached a crisis, the bank’s confidence in you is likely to be significantly reduced. You will have to take action to demonstrate you know and are in control of what is happening in your business (e.g. robust cashflow forecasting) and that you can take tough decisions (e.g. on cutting costs or staff) to restore the bank’s confidence.

But even if the bank has confidence in your integrity and abilities, if you are needing to turnaround your business, by definition, it is in some kind of trading difficulty. So, how keen would you be to lend your money to a business in difficulty? What questions would you ask? The principles involved when your company borrows money from a bank are exactly the same as when you, as an individual, borrow money to buy a house. When you apply for a mortgage, the lender wants to know two things before they grant a mortgage:

• 1.What you earn, so they can see that your stream of income (your cashflow) is enough to allow you to make the payments. For a company, your cashflow and profit and loss forecasts are estimates of future earnings on which the bank will need to judge whether sufficient money is going to be made to repay the loan. In the case of a company in difficulty, the projections are going to come under sceptical scrutiny and therefore need to be well thought through, robust and realistic.
• 2.What is the value of the property compared to the loan, so that if you cannot pay they will be able to take possession of the house (their security) and sell it for enough to recover their loan.

Example

Mr H buys a house for £100K. His bank is happy to lend him 80% of the value on a mortgage (£80K). Three years later, Mr H has paid off £5K in capital and the house has risen in value by 50%. The bank’s security position has improved by £55K:

	Initial	Current
	(£000)	(£000)
Property at current realisable value	100	150
Outstanding loan	(80)	(75)
Surplus security	20	75
Loan to value ratio	80%	50%

In the housing market, this surplus is usually referred to as ‘equity’.

The statement in the example ignores any costs of realisation (e.g. estate agent fees). Whilst these costs can be significant (particularly in the case of a company), for the purposes of estimating security on an ongoing basis, banks usually ignore these costs to keep the tracking and calculation of security cover simple. In a crisis however, costs start to be considered in more detail and can affect the bank’s view of the value of its security.

For a company that has a variety of assets and liabilities, the position is more complex than that of an individual taking out a mortgage to buy a single asset, but the principles are the same.

If your bank becomes sufficiently concerned about your position, they may send in investigating accountants (who will normally be from an insolvency practice) to conduct an investigation, often known as an Independent Business Review (IBR). Part of their report to the bank will almost always be a detailed estimate of the value of the bank’s security known as an estimated security position statement, estimated outcome statement or an estimated statement of affairs (S of A). This forms a vital part of the bank’s decision-making process as it quantifies their possible exposure in the event of failure. By rolling the figures forwards on the basis of the forecasts, they can also see whether the bank’s position is likely to improve or worsen by providing the company with support.

In many cases however, the accountants will be under instructions not to disclose their estimates to you and in practice it will assist you to have this information as early as possible in the process.

The easiest way to demonstrate these steps is by use of a worked example.

Obtain an up-to-date balance sheet

Example

Here is an extract from Company H’s balance sheet where the bank has a standard UK bank charge (‘debenture’).

Company H balance sheet	£000	£000
Fixed assets
Land and buildings	20
Plant and machinery	100	120
Current assets
Debtors	200
Stock       Finished goods	50
Work in progress	50
Raw materials	50	350
Current liabilities
Trade creditors	(80)
HP	(10)
PAYE	(20)
VAT	(10)
Overdraft	(200)	(320)
Net assets		150

The company, which employs 20 staff, has net assets, so you might think that the bank would feel secure. However, to check we need to produce an estimated security position statement by applying the steps set out above.

Reorder assets and liabilities according to the relative priorities

A normal UK bank debenture will give the bank ‘fixed’ and ‘floating’ charges. Assets must therefore be divided into those subject to the bank’s fixed charge (generally land and buildings) and all the other assets, which will be covered by a floating charge. If it has to call on its security, the bank will be paid out first from the net proceeds of sale of the fixed charge assets.

The debenture will probably state that plant and machinery (fixed assets in accounting terms) are covered by a fixed charge, but in general this will not be effective and therefore plant and machinery come under the floating charge. If, however, the bank has taken a chattel mortgage over specific listed items of plant and machinery, then these items should be included under the fixed charge.

For many years debtors (a current asset in accounting terms) have been regarded as effectively covered by banks’ fixed charges. Unfortunately at the time of writing the situation has become confused, firstly as the result of the decision in a case called Brumark which suggested that banks’ fixed charges will only operate as floating charges, and then a further case called re Spectrum Plus which ruled the other way. Since the changes in the Enterprise Act discussed below which reduced the types of preferential claims, the impact of the distinction between fixed and floating charge assets has been reduced in many cases. If, however, the level of your debtors means that their treatment will significantly affect the outcome of your estimate, you should check the current position with a professional advisor.

The proceeds of sale of the floating charge assets are used to first settle certain creditors (known as the preferential creditors). Under the Enterprise Act with effect from September 2003 these are now broadly limited to employees’ arrears of wages of up to £800 per month for the last four months (but not redundancy).

Only once the preferential creditors have been paid is any surplus cash paid to the bank under its floating charge. And only once the bank’s lending has been settled are any funds then available for all the other creditors (’unsecured creditors’). This has generally meant that there has been very little left for unsecured creditors in insolvencies. Under the Enterprise Act therefore, where a floating charge has been created after 15 September 2003 a portion of the cash generated from floating charge assets will be retained in a ‘ring fenced fund’ for the benefit of the unsecured creditors. If you have such a charge you should consult a professional advisor as to the impact on your security position.

Restate assets at current values

Realistically, for the purposes of most discussions with banks, this usually needs only to be done for land and buildings where current value and book value are based on original costs which may be wildly different from actual current value. In Company H’s case the property is recorded in the books at its cost of many years ago of £20K (book value). However as the property is currently worth £60K this is the value that will need to be shown in the security statement. Investigating accountants will usually seek at least a ‘drive by’ estimate of any significant property’s value from their agents to confirm the likely value.

If, however, plant and equipment have a significant value, then it may also be worth requesting a ‘desktop’ valuation of its realisable value from chattel agents.

Identify and net off certain specific liabilities

Creditors fall into one of three general categories for deciding where they rank in priority to be paid:

• secured creditors with fixed or floating charges;
• preferential creditors; and
• unsecured creditors.

There are, however, some specific items to be wary of.

Where plant and machinery is held under HP or a lease, it is not actually the company’s property. Nevertheless, if the value of the plant exceeds the HP or lease liability, then this surplus value (’equity’) will be available to the bank as you can pay off the HP, sell the assets and realise the difference in cash. So for Company I, the £10K HP liability will need to be deducted from the value of the assets to achieve a net amount of assets available for the bank.

If the outstanding HP is greater than the value of the assets, the net value of the plant and machinery available to the bank should be shown as nil. Any apparent deficit suffered by the HP company would be added to unsecured creditors.

Similarly, if you factor or invoice discount your debts, the amount due to the factors/invoice discounters must be deducted from the debtors to work out the net available to the bank. This is because your factors/invoice discounters will have negotiated an effective fixed charge over debtors that is not affected by the recent legal cases, giving them priority over the bank.

Apply appropriate recovery estimates

Having established realistic current and book values for the assets, these will then need to be discounted to reflect the assumptions that banks and their advisors will make about the values that can realistically be expected to be achieved if the business fails. These will often be estimated by investigating accountants on both the basis of a ‘going concern’ sale, where the business may be traded on in receivership or administration and sold as a trading entity, and a ‘gone’ basis reflecting a liquidation and break-up of the business.

Some typical rules of thumb that are applied are shown in Figure 12.

Example

The result of applying these rules to Company H’s balance sheet is a security position statement showing:

	Value	Realisable percentage	Security value
	£000		£000
Assets subject to a fixed charge
Land and buildings	60	75%	45
Less due to bank			(200)
Surplus/(deficit)			(155)
Assets subject to a floating charge
Plant and machinery	100	20%	20
Less HP	–		(10)
Debtors	200	50%	100
Stock         Finished goods	50	40%	20
Work in progress	50	–	–
Raw materials	50	20%	10
			140
Less preferential creditors
Employees (say £1,000 each)	(20)		(20)
Available for the bank			120
Bank deficit from above			(155)
Bank surplus/(deficit)			(35)
Available for all other creditors			0

As things stand therefore, the bank is facing a deficit on its security in the event of a liquidation or receivership, before allowing for the costs of realisation. If as a director of Company H you have personally guaranteed the borrowings, you should also be concerned, as in the event of a shortfall the bank can call on you to make good their loss. There is also clearly nothing in the pot for the £80K of unsecured trade creditors, the £30K owed to the Inland Revenue and HM Customs & Excise, or any employee redundancy claims or other contingent liabilities (e.g. future warranty claims).

Whilst a full estimate of a bank’s security position is a complex matter, requiring specialist assistance in the valuation of assets and in assessing reservation of title clauses, this approach should provide you with a sufficient basis to understand and to discuss with your bank how confident or exposed they feel about your business.

By rolling forward an estimated outcome based on your balance sheet for the forecast period, you can also see how the bank’s security position is likely to be affected by further trading as well as demonstrating to them that you understand the issues involved. Also, by establishing whether you are asking your bank to become more exposed or whether your action will help your bank to improve its position, you will be putting yourself in a situation where you can ask for your bank’s support.

KEY POINTS

• Can you pay your debts as they fall due? If not, you are insolvent. Don’t panic, but do get professional advice. Contact help@turnaroundhelp.co.uk for a referral to a reputable local adviser.
• Work out how much cash you are going to need in the short term. This is the first step towards making sure you have it.
• Work out how comfortable/exposed the bank is, and will become, before you sit down to talk to them about how much cash you need.
• Use the tools discussed in this chapter to help you keep track as you progress.