Going Concern and Liquidity and Solvency

Let’s be honest, most business owners have no idea what the title of this blog even means!

If you’re one of those business owners, it’s a good idea to start taking these strange words seriously. They’re not that difficult to understand, so if you ready to get on top of your business and its going concern and liquidity and solvency, carry on reading to find out more.

A good place to start: Going Concern

Going concern is an accounting term for a company that has the resources needed to continue operating indefinitely until it provides evidence to the contrary.

I.e. – Do you have enough cash resources (or other resources) to continue operating, and to cover current and future liabilities (overheads, supplier payments etc.)?

Financial statements need to be prepared on an alternative basis, and not on a going concern basis, when the entity is no longer a going concern. This is when management either intends to liquidate the entity or to cease trading, or has no realistic alternative but to do so.

Management is required to inform the preparer of financial statements when they are not confident that the company will continue to be a going concern for the foreseeable future.

How does a business owner assess a company’s ability to remain a going concern?

The following questions should be considered and answered (this is not an exhaustive list, but should give you some guidance):

Current and expected profitability

  1. What are the different scenarios that may arise as a result of the changing economic and business circumstances (both changing scenarios or changes within a scenario)? 
  2. Expected impact on liquidity (cash) and profitability 
    • Does the entity have access to liquidity? 
    • Are there any significant payments due to creditors and shareholders? Does the company have the ability to reschedule these payments? 
    • Impact on payments or return patterns of customers with long-term financing. 
  3. How stable is the company’s supply chain?
  4. Can the company continue to afford employee costs and benefits?
  5. Is the company able to continue to operate at normal capacity? 
  6. Are overhead costs consistent?
  7. Will there be any changes in markets which will impact imports/exports of raw materials and goods? 
  8. What is the outlook on commodity prices.
  9. Do you have any implementation delay penalties if there is a delay in your work/projects?

Debt repayment schedules

  1. What loan covenants do you have, and are you expecting any breaches thereof in the near future?

Potential sources of replacement financing

  1. Will the entity have sufficient liquid funds and access to facilities to enable it to meet its obligations as they become due?  
  2. Consider if the cost of, or access to capital and funding sources have changed and whether it is likely to change or continue to change.

Subordination of shareholder/director loans

  1. Will there be a need for shareholders/directors to subordinate their loans (i.e. agree that no payment is due for these loans to reduce the company’s liabilities and return the company to a liquid position)?

What next?

If any of the above questions have raised concerns for you, or cast doubt on your company’s ability to continue as a going concern, you need to document these concerns and possible solutions to your concerns. Regardless, you will need to share your thoughts and stance on the above (and other pertinent) issues with The Accounting Company.

If your company is in a loss position for this past year-end, and is in a historical loss position for all its years of operation, and if you have creditors whom you will not be able to pay, this is cause for concern.

If you come to the conclusion that your company will not be able to return to a profitable position, this is something that needs to be taken seriously in light of The Companies Act requirements for directors.

Next: Liquidity and Solvency

In addition, directors/members and business owners are required to perform solvency and liquidity analysis work on their business. 

What is liquidity?

Liquidity refers to the ease with which an asset can be converted into cash. I.e. How quickly can you sell the company car (for cash)?

How does a business owner assess a company’s liquidity and solvency?

There are two main ratios which come into play when assessing liquidity. Let’s take a look at them below:

Current ratio (Current assets vs Current liabilities)

The current ratio represents an entity’s ability to pay short-term obligations (those due within one year). 

Quick ratio (Cash + Receivables vs Current liabilities)

The quick ratio represents an entity’s ability to pay short-term obligations (those due within one year) using its most liquid assets. The most liquid assets are assets that can be converted quickly to cash. 

As a guideline, both of the above ratios should be greater than 1:1, i.e. 2:1. This is often business dependent, so what might be good for one company, is average for another company.

An important solvency ratio is below:

Debit Equity ratio ((Total Current Liabilities + Total Non-Current Liabilities) / Total Owners Equity)

The debt to equity ratio represents an entity’s financial leverage. The ratio is a measure of the degree to which an entity is financing its operations through debt versus wholly owned funds. A lower ratio reflects the ability of shareholder equity to cover all outstanding debts.

What next?

If your company’s liquidity and solvency ratios are not where they need to be, it is a sign that you seriously need to focus on your cash generating opportunities.