How to identify a company in financial difficulty

Businesses are facing difficult and challenging times.  Businesses in many sectors are basically struggling.  The challenges include, amongst a whole host of other issues, reduced investment and growth, reduced consumer confidence and online retail trends.  In a climate where hardly a few weeks or months seem to go by without a major insolvency announcement, this article looks at the "decline curve" of a business in financial difficulty. The note explains what insolvency means and how to react to it and touches on the rights of employees during a liquidation.

Plotting the course of a company’s decline

Insolvency comes at the end of a period of declining business. By the time a distressed company becomes insolvent (or is near to insolvency), it has limited options and so do those who contract with it. The challenge is to spot the signs of decline and react ahead of the game.

 Phases of decline

There are, typically, three phases to the decline of a company:

• A company loses profitability because of weaknesses in its business.  Some of the warning signs of this stage are decline in reputation and market perception, failing gross profit, new projects during difficult times etc
• The business cannot fund any activity outside its immediate operations and has difficulty meeting commitments to lenders and trade creditors.  Some of the warning signs of this stage are: a fall in staff morale, the company fails to meet its contractual obligations, the company takes on a more contentious approach in dealing with outstanding obligations,  a change in management structures so you see a more hands on approach within the business and the business seeks new funding or re-financing etc

• The company suffers a critical shortage of cash, forcing it to use all the cash generated by the business to meet debts as they fall due.  Some of the warning signs are erratic payments, resignation of employees responsible for finance, suppliers putting the company “on stop” etc

Unless the company takes action to address the difficulties it faces, over time:

• The pace of its decline accelerates.
• The options available to the business and those that deal with it narrow, making a successful rescue or restructuring less likely.

When is a company insolvent?

Section 384 of the Insolvency Act No. 18 of 2015 sets out the circumstances in which a company will be deemed unable to pay its debts (and therefore susceptible to being wound up):

• A creditor has served a statutory demand on the company and 21 days have passed without that demand being satisfied to the creditor’s satisfaction.

• A creditor has a judgment against the company and has tried to enforce that judgment without success.

• The company is cash flow insolvent. The company is balance sheet insolvent.

How to react to financial difficulties: Overview of options available to the distressed company

The primary focus of a distressed business is usually on reducing the immediate financial pressure, to create time in which to address the flaws in the business model.

This requires a combination of improving the liquidity of the company’s assets (to enhance the amount of free cash in the business) and reducing liabilities.

Distressed companies often explore:

• Swapping debt for equity.
• Negotiating standstill agreements, to keep liabilities at a fixed level for a period.
• Using invoice discounting or stock finance to improve the liquidity of the company.
• Implementing a company voluntary arrangement (CVA) with creditors.
• Entering administration.
• Liquidation of the company as a last resort.

From the perspective of an employee

It is critical for an employee to understand the order in which payments are made during a liquidation.  

The expenses of a liquidation will have priority over all other payments.  These expenses include the remuneration of the liquidator and the expenses properly incurred by the liquidator in performing his duties; the reasonable costs of the person who applied to court for the order placing the company in liquidation and the amount of costs incurred by a creditor who protects or preserves the assets of the company for the benefit of the creditors. 

The employees’ claims have second priority after all those claims have been paid. Employees’ claims include wages or salaries in respect of services provided during the 4 months before the commencement of the liquidation, any holiday pay payable, any compensation on redundancy, amounts deducted by the company from wages or salaries in order to satisfy their obligations to other persons such as PAYE, NSSF or NHIF.  However, it must be noted that these amounts may not, in the case of any one employee, exceed two hundred thousand shillings.

The Employment Act No. 11 of 2007 at Sections 68 and 69 also set out some additional debts which may be due to an employee in the event of an insolvency including notice pay, compensation for unfair dismissal, reimbursements of fees paid by an apprentice and it also provides for a longer limitation period than the 4 months mentioned in the Insolvency Act.  The reconciliation of amounts due to an employee under the two Acts will in the circumstances be decided by the Industrial Court.

Article by Carole Ayugi,

Managing Partner