Why Directors Need to Act Now to Avoid Financial Distress
The coronavirus pandemic has put the world into a tailspin. All businesses are affected as they come under unprecedented pressure from the disruption and as trade evaporates. For companies experiencing distress, the earlier its directors take action to perform a financial health check and monitor the situation, the better the prospects for survival and recovery.
According to the World Health Organization’s estimate, 10% of the world’s population may have contracted coronavirus. The global pandemic has not just affected the physical wellbeing of people, for many businesses, especially those that rely on customer contact and the movement of people, the virus has also resulted in the evaporation of their revenue drivers and supply chains.
In Hong Kong, the impact on businesses and individuals are already showing. As at Quarter 4 of 2020, the unemployment rate stood at 6.6% which was a 16-year-high, while year-on-year GDP has contracted by 3.5% in 2020 after suffering its biggest fall of 9% earlier in Quarter 2. As Hong Kong navigates the next phase of an economic downturn, and government support dries up, it is expected that financial distress will be felt by businesses and individuals throughout the city on an extraordinarily wide scale. The number of bankruptcy petitions in May 2020, for instance, has already exceeded its previous historic peak registered in the 2009 global financial crisis.
The businesses under highest pressure are likely to be brick and mortar high-street retailers, restaurants, bars, exhibitors, and tourism and travel-related industries (such as airlines and hotels). In other words, those rely on freedom of movement and human interaction are most likely to be hit hardest as they have witnessed a cataclysmic drop in business activities due to the necessary lockdown measures.
A pragmatic and positive approach to fight business distress
With all that is going on, creditors including banks and landlords are offering degrees of forbearance on debts, government is providing support to companies and individuals. It is sometimes difficult to know after surviving one temporary financial distress after another, whether a company’s core business model is still sound in the long term.
Directors need to be conscious of the situation and on top of the issues that arise, particularly as the immediate economic shocks of the pandemic recede but new shocks emerge with government assistance drying up, and landlords or other creditors less willing to forebear any longer. If not appropriately managed, financial distress can spiral out of control quickly. As a business’ cash-flow deteriorates, it becomes a vicious circle to maintain operational “breathing room”. You need orders to generate cash, and you also need cash to service upcoming obligations.
Therefore, directors and management must stay on top of the early warnings of financial distress. These traditionally include liquidity or cashflow becoming tight or that your borrowing facilities have been exceeded. This then leads to malperformance such as payments to debtors or suppliers being stretched or not being settled at all, interest payment being deferred, accessing a “hardcore” overdraft facility or other sources of emergency funding (often at very high rates of interest), or margins being squeezed as business’ revenue and profitability are declining.
Once the business enters this territory many directors will, understandably, be further occupied with the financial viability of the business rather than the day-to-day operations, which can further compound the distress. Directors should remain calm and strategic, leading the business to regularly review its ability to cope with upcoming debts, including the ability to renegotiate or refinance the debts, and the ability to generate cash in the short term through sales, debtors, assets or cash reserves.
In a growing business and a buoyant economy, some poor business practices, issues or even business models can be sustainable, or at least tolerated. But once the tide goes out, a lot of underlying problems will be exposed. While this can be painful, it is also indisputably an opportune time to re-examine businesses, restructure or dispose of undesirable parts to prepare for new growth opportunities, once things return to some degree of normality.
Directors should consider consulting an independent external consultant to objectively assess its financial health and viability, in order to be presented all options (including restructuring or voluntary liquidation) and make decisions at the company’s best interest.
At this point, we need to emphasize an important issue: when a business is in financial distress (that is, once the business is entering the insolvency zone), the duties of directors to exercise a duty of care, skill and diligence and to act in good faith extend beyond shareholders, to where they must consider the interests of creditors first.
Immediate actions for a company in distress
Acting quickly matters, particularly as the situation continues to remain volatile. The most pressing goal in the short term is to improve cashflow, and this means actions such as raising invoices, chasing late payments, negotiating terms to bring in cash faster or deferring non-essential payments. This may even include some harder decisions such as shutting down parts of the business or reducing headcount. Together the aim would be to enable you to get through the worst of the pandemic first.
In the mid-term, assuming you have a viable business at its core, you might want to renegotiate existing finance, such as a reduction in interest rates, or an extension or a moratorium on payments. Directors might also look at new investment or reissuance of shares for a new capital injection, and even the sale of non-core assets or divestment of non-core businesses. In the longer-term, a more fulsome operational restructuring and business process improvements should also be considered.
If the market outlook is negative and, after a balance sheet restructuring, there is limited business growth or operating efficiency left in the company (i.e., there is no hope of survival), then directors should consider a voluntary liquidation and the orderly disposal or wind-down of the company.
Do not delay
In any economic downturn, many companies will eventually bring in independent consultants. However, companies who can survive and thrive beyond a crisis often belong to those who bring in sufficient help to fight the fire when it is still small. External consultants will provide fresh ideas on how to improve existing processes and systems, and to execute on harder decisions, such as long-standing business lines, exiting leases or reducing headcount, which may be needed to make long-term survival possible. These advisors can also help you re-negotiate existing obligations, refinancing or restructuring, by convincingly presenting the company’s financial position and operational prospects to existing or new lenders or investors.
No one knows how long this situation will last, or what the situation will be in a year’s time. The number of options open to a business, however, decreases as its situation gets worse, so it is crucial for directors and management to face financial distress head-on as soon as it occurs, diagnose each problem at its cause, so as to take early and proactive action to keep the company afloat.
This story first appeared on The 21st Century Director.