Risk of overtrading
Although your company may well be profitable, it doesn’t mean that cash is always available and, as a director, you can be sued personally for trading whilst insolvent. What can you do to prevent this?
Cash is king
It is more than a business cliché to state that “cash is king”. While profit, turnover and even market share are all indicators of success, if there’s no cash in the bank to meet the monthly bills, wage runs and loan payments, the company will ultimately fail. Without considering the cash flow, sometimes that dream contract which should substantially increase your company’s turnover can turn out to be a nightmare, even though it is profitable.
New contract
Say a new customer wants to put in an order with your company worth £5,000 a month. It will cost you £3,000 a month in wages for new staff and other costs to fulfil the order. You won’t get paid for 60 days but it’s still a profitable order so you take it. But should you?
Cash flow forecast. Not until you’ve sorted out the cash flow! In the first month you pay out £3,000, and at the end of it you issue your first invoice for £5,000. You pay out £3,000 in the second month and £3,000 in the third month as well, and it’s only at the end of the third month that you will receive the first £5,000 from your customer - assuming you get paid on time. So your overdraft will increase by £9,000 because of this order until you start receiving the payments and reducing it again. Even then it’s going to take five months just to pay off your borrowings.
Overdraft capacity? Of course the big problem is that you probably don’t have a spare £9,000 before you hit your overdraft limit. So the result of this supposedly profitable order is suppliers unpaid, cheques bouncing, charges for telling you that your cheques have bounced, and urgent calls from your bank’s Business Manager requesting you visit at your earliest convenience!
Tip 1. Before taking on a big new contract, always look at the time between cash receipts and cash going out to determine the funds your company requires. Your bank is going to be much more willing to increase the company’s overdraft for a temporary period if you arrange this in advance. And the company will also avoid those unauthorised overdraft charges.
Tip 2. Look very carefully at your credit terms, both those you offer customers and those required by suppliers. If possible, try to make sure that your customers’ credit terms are shorter than your suppliers’.
Personal liability
Wrongful trading - the risks. As a director, it’s extra important to make sure you keep on top of the company’s cash flow. If the company runs into financial difficulties and is eventually liquidated owing money to its suppliers, the court may order you to personally make a contribution to the deficit. However, this will only be the case if you knew, or ought to have known, that the company was insolvent, but you failed to stop trading or failed to take reasonable steps to minimise the deficiency.
Tip. Regularly review the company’s financial position in order to assess whether the company is solvent. This will generally involve the preparation of regular cash flow forecasts - in collaboration with your accountant if necessary.
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