Keeping our clients updated with practical business advice during the Covid-19 pandemic.

Visit our hub

Protect your business in uncertain times

Financial health

Protect your business in uncertain times

As Brexit is delayed again, the associated economic and business risks continue to come into focus, so it’s more important than ever that directors assess the financial health of their core customers and suppliers.  Whilst not directly linked to Brexit, the recent collapse of Thomas Cook is a timely reminder that even household names can and do go bust, leaving key stakeholders in dire straits.

To mitigate the risk of working with unstable businesses, directors should, at the very least, perform credit checks on their customers and suppliers.  There are many websites which provide these checks – for a fee. These can be useful, but they do not provide the qualitative analysis which we describe further below.  What they do provide, though, are helpful credit risk analyses and “credit scores” which can give you a degree of confidence, especially with customers and suppliers who are new to you.

In addition to statistical-based credit checks, directors should seriously consider reviewing the accounts of their key partners. Companies House provides free access to all UK limited companies’ and LLPs’ annual financial statements (as well as all other statutory filings).  Small companies are permitted to file reduced-disclosure accounts (which exclude the profit and loss account), but even these can tell you plenty about the business.

Below, we consider the warning signs that a business might be in financial difficulty:

  • Strategic report – medium-sized companies have to include this, and, if completed properly, it is an invaluable source of qualitative information on their performance for the year, principal risks and uncertainties, and future outlook.  In particular, directors should be commenting on Brexit-related risks, where applicable.
  • Audit report – the auditors express an opinion on whether the financial statements show a true and fair view of the business’ position and performance, as well as reporting on whether the going concern status is appropriate (i.e. whether there is uncertainty about the ability to continue trading for at least 12 months from the directors’ approval of the accounts).  

Look for a “Basis for Qualified Opinion” heading in the audit report, as this means that it is not a “clean” opinion.  The reason for a qualified opinion may be perfectly innocuous, but it may reveal something more concerning (e.g. are the auditors concerned that the company’s debtors are irrecoverable, which in turn might create cash flow problems?).  

Check the “Conclusions relating to going concern” section of the audit report for details of any concerns from the auditors about the business’ trading outlook or liquidity.

  • Profit and loss account (medium and large companies only) – this is fairly obvious, of course, but key points to look out for are significant reductions in turnover and profit, along with a review of the gross profit margin and overheads (which are important in indicating the business’ ability to control its costs, especially where revenues have grown and “over-trading” may be an issue).  However, even if a business is profitable, it may be in poor financial health overall.
  • Balance sheet – there are two key indicators of a business’ financial stability: the bank balance; and the net current asset position.

Compare the current year’s bank balance with last year’s.  A significant reduction may simply be a matter of timing of invoicing, so have a look at the changes in trade debtor and trade creditor balances too.  Equally, it could just be down to capital expenditure, so check the values of tangible fixed assets against last year.  Of course, if the business is medium or large, it will prepare a cash flow statement, which will allow you to understand exactly what has caused the movements in bank balances from one year to the next.

The net current assets of a business indicate to what extent it is solvent.  If the short-term liabilities exceed current assets (stock, bank balances and debtors), then this suggests a potential problem, since (at least at the balance sheet date) the business lacks the liquid assets to settle its liabilities.  In these circumstances, we would expect there to be a disclosure in the accounts to explain why the directors have prepared the accounts on the going concern basis (see below).

In addition to the above, for small businesses which do not file a profit and loss account, it is worth looking at the difference between the current and prior year profit and loss reserves at the foot of the balance sheet.  If the current year’s reserves are lower than the previous year’s, this indicates either that the business suffered a loss in the current year, or that the dividends declared for the current year exceeded the profits for the year (or both!).

  • Notes to the accounts – there are a few areas to be aware of:
    • Going concern disclosures – if the business has suffered a substantial loss or has net current liabilities, there should be a disclosure to explain why the directors have prepared the accounts on the going concern basis (i.e. why they consider the business to be able to trade through the next 12 months). This should give some useful, qualitative information on the availability of funds and trading prospects
    • Debtors note – a rise in trade debtors with no significant growth in revenues may indicate that the business has issues with recovering its debts, which impacts on cash collection and liquidity.
    • Creditors note – similar to above, if trade creditors have grown, with no commensurate increase in costs, this may suggest that the business is playing for time and delaying payments to its suppliers because of actual or anticipated cash flow difficulties. 
    • Contingent liabilities – this note will disclose future potential liabilities which will only crystallise upon certain events occurring, e.g. a compensation settlement which is contingent on a legal case whose outcome cannot yet be predicted.  If a business has a weak balance sheet, the fruition of such a liability will only compound the situation, and so it should be borne in mind.

Checking the financial health of your key customers and suppliers has always been crucial, and with the (hopefully) short-term disruption which Brexit is likely to bring, this is more important than ever.

If you have concerns that the accounts of a customer or supplier are exhibiting the warning signs noted above, you might consider contacting that business to find out some more.  For new customers and suppliers, for instance, you might ask for the latest set of accounts, if they are yet to be filed at Companies House.   In the case of new customers, you may then choose to offer shorter credit terms, or even request payment in advance.

Here at Creaseys, we see sets of accounts day in, day out – preparing them, auditing them, analysing them.  We know what to look for, so if you need help with a particular set of accounts, please call your usual Creaseys contact on 01892 546 546