Assessing a manufacturing company’s insolvency risk generally comes down to two perspectives: the technical approach, which focuses on the net asset position and the commercial approach, which examines a company’s ability to pay its debts as and when they fall due.
For manufacturing businesses, you must consider both of these approaches alongside operational efficiency, supply chain resilience and working capital intensity. These elements are the true drivers of financial performance. To understand whether a business is at risk of trading while insolvent, we need to look beyond an underwater balance sheet. Here are the key operational red flags to watch for and how they present practically on the factory floor.
Trading losses
Trading losses are not always an indicator of insolvency, however if not addressed, will erode a business’s liquidity and potentially pose a threat to a company’s solvency. In manufacturing, margin pressure may arise from increased input costs like raw materials, energy and labour or inefficient production processes, which can accelerate losses.
Where trading losses are apparent, you need to identify who is funding the losses.
- Is a company director or related party funding the losses? If so, is this sustainable and is the funding being made in a conscientious manner or in an ad hoc way that offers little protection for the funding party?
- Is the business not paying certain creditors such as the Australian Taxation Office (ATO)? This is not a long-term strategy and if creditor management is required in the short term, it is important to assess a creditor’s will and skill to affect the business.
- Are relationships with critical suppliers showing signs of strain? In manufacturing, critical suppliers, example raw material providers or component manufacturers, often have greater leverage than statutory creditors due to their ability to halt production.
- Is third party finance being used or needed? A strategic plan for funding and knowing how much runway it provides is critical. Consider whether funding is being used to support operational improvements or merely to cover ongoing inefficiencies.
Poor cash flow
A business can be highly profitable on paper but still burn through cash. Manufacturers are uniquely exposed to working capital stress due to heavy inventory holdings, long production cycles and extended customer payment terms.
When discussing cash flows, the focus should be on:
- Whether poor debtor collections are a result of lack of focus / effort in collection process, customer credit issues or low product or service quality?
- How efficiently inventory is managed, including turnover rates, obsolete or slow-moving stock, and exposure to demand volatility.
- What is the tipping point for enforcement action by a creditor not being on time and what actions are available to creditors?
- Is there any capex that can be deferred or non-core assets that can be sold? Assess whether delaying maintenance capex could increase breakdown risk and future costs.
- Do the current financing facilities align with current funding needs or were facilities structured at a time when the company was in a more stable position? Consider whether inventory and receivables financing structures remain appropriate given current production volumes.
Pinning hopes on the next ‘big contract’
Hope is not a strategy and chasing revenue just to ‘feed the beast’ could impact margins. This is particularly relevant in manufacturing businesses where large contracts may require upfront investment in labour, tooling or materials before cash is received.
So, at times of risk the questions that should be asked are:
- Is there a clear, data-backed business case and measurable contribution margin for this contract?
- Does the contract have sufficient flexibility to absorb sudden supply chain price increases?
- Do you have the actual capacity to deliver, factoring in plant utilisation, labour availability and supply chain reliability?
Inability to produce timely and accurate financial information
Bad data leads to bad decisions. In manufacturing businesses, a lack of visibility over production costs, wastage, and unit economics can significantly distort reported profitability.
In the short term, distressed companies may need to prioritise simplified but accurate reporting rather than system overhauls. Cash flow reporting should be the focus rather than profit and loss. Directors should take control of this reporting and not delegate it. This lets them guard cash outflows and pull the right levers to lift cash inflow. Measuring actual performance against forecasts creates accountability.
Negative business environment
The physical appearance of business premises may decline as a business slips into distress. Upkeep and maintenance move down the priority list as directors fight fires elsewhere. This decline is usually gradual but obvious to stakeholders who visit occasionally, and the confidence of customers and suppliers will bear on the prospects of the business.
Employees are another key stakeholder. They attend the premises weekly and their morale can greatly affect performance and the likelihood of a turnaround. Director disputes and senior staff turnover can disrupt operations, particularly where key personnel hold technical or production knowledge critical to the business.
Poor relationship with financiers
Solvency is not limited to the cash immediately available to pay debts, so understanding what can be raised through debt or equity injections is a key consideration.
Red flags that could trigger a conversation about the risk of insolvency include:
- Inability to seek further funding from current financier
- Rejection of request to rollover a facility
- Unable to refinance with alternative financier
- Funding obtained with costs well in excess of market rates, and
- Due diligence by investor raises concern about business model or that balance sheet is beyond repair.
Tightening of covenants linked to inventory levels or earnings may place pressure on manufacturing businesses during downturns.
Inability to pay taxes when due
As cash flow dries up, decisions may need to be made on which creditors are paid. A supplier’s behaviour can have a greater bearing on short term trading so, the squeakiest wheel often gets the oil first.
This means that when taxes become due, payment is moved down the priority list. The first instance of deferring statutory debts is something liquidators look for when assessing solvency and this should give Directors pause to think about long-term viability.
Although statutory creditors may have limited in affecting operations short term leverage, the ATO rarely accepts haircuts to their debts. Consequences of non-payment can include public disclosure of arrears, garnishee notices, Director Penalty Notices and disqualification from safe harbour protection.
Creditor disputes
Legal action will be the last step in creditor disputes and often, due to commercial considerations, disputes will not escalate beyond informal demands and negotiations. Liquidators understand this and will not just look for formal legal disputes when assessing the point a company may become insolvent.
For manufacturing businesses, disputes often arise from product quality issues, delivery delays or contract specifications and can quickly escalate into cash flow issues.
Suspicions of insolvency should be raised upon the occurrence of:
- Significant aged creditor ledger
- Creditors stopping of supply or implementing cash upon delivery terms
- Material changes of terms and rates to recoup losses and
- Special payment arrangements with creditors.
If disputes are escalated to formal legal action, this becomes public information collated by credit reporting bureaus. This could exacerbate distress as obtaining credit and dealing with stakeholders becomes more difficult as the market becomes informed on the potential solvency risk.
For help to determine the level of distress your business is experiencing and its risk of insolvency, please contact your local William Buck Restructuring and Insolvency expert.
