Distressed Balance Sheets – The Board’s Role

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“Things are pretty tough in the market these days”. How often do we hear that? I’ve rarely heard anyone say over the years that “conditions are ideal right now”.

 

Whether you are a commercial business or NFP organisation, staying in business is tough. Cash is hard to come by from government, donations or trading activity, so it’s inevitable that financial challenges arise from time to time in many organisations.

 

In some cases, this can be an isolated hiccup, but in other, it is the sign of a more serious structural failing of the organisation’s finances.

 

So what should the board do if it knows or suspects it is in this position?

 

Before we even get there, there are two questions you need to ask:

 

    1. Can you rely on the integrity of the underlying financial information?

    This is a whole separate topic that we can’t do justice here, but there are warning signs that all may not be right. These include:

    • auditor discomfort
    • a high incidence of adjustments and corrections after month end
    • high staff turnover in finance and,
    • if you just feel the finance person doesn’t know what’s going on, or is shielding the hard truths from you.

     
    2. Is the balance sheet ‘distressed’?

    Assuming you are comfortable with the accuracy of the financial reports you receive, the second step is to identify if the balance sheet is indeed “distressed”. There’s no clear definition of what this is, but there are some good pointers to consider:

     

    • Net assets: Look at your net assets, the other side of the balance sheet to equity. Your organisation’s net assets must be positive and should contain a buffer. Ideally, net assets should be sufficient to cover operating expenses for a period somewhere between 3 and 24+ months. I like a year’s expenditure buffer in the bank.

     

    • Cash: Cash, or lack thereof, which has been the downfall of many profitable businesses throughout time. Even if total net assets are healthy, too many of them may be tied up in fixed assets such as equipment, vehicles and so on. So now put the spotlight on the current ratio. This simply divides current assets by current liabilities. The answer should be more than 1. Preferably a good bit more. If it’s not, you may well not have funds available to meet financial obligations as they fall due. There are several other ratios and tables that can help you understand the health of your balance sheet, and a range of experts who may be able to help you implement and interpret them.

     

    If you feel your balance sheet may be in distress, you need to take action. Burying your head in the sand or keeping your fingers crossed for improved profitability won’t help. Depending on your legal structure, most organisations’ directors can be held personally liable for trading while insolvent, so take this seriously.

     

    Here are the steps you need to take:

     
    Get help
    Bringing someone else in to review the situation can be informative and even cathartic –acknowledging that there is an issue. The first step is often the hardest.

     
    Try to understand how the issue has arisen.
    Look at trend analysis. Tracking the movement of key figures over time can be very illuminating. Compare month on month or year on year.

     
    Look at your staffing
    Has staffing increased on the back of unfulfilled grant income expectations? Perhaps your organisation has a favourite operational activity, which fits well with its aims but that everyone knows can’t come close to covering its costs. If the rest of the organisation isn’t generating enough cash to cover this division, then maybe some hard decisions have to be made about whether to continue it. Perhaps the environment in which your organisation operates has changed and it is simply no longer viable under the current structure. Do you need to think about merging with a like organisation? Such a move will inevitably rouse strong reactions and emotions among the board and within the organisation, but giving it serious consideration is a whole lot better than doing nothing as you slide into insolvency.

     
    Don’t get too involved.
    If you or another director have financial skills, it’s easy to want to jump in and get involved. It’s not generally a good idea. The board’s role is to govern and getting involved in day-to-day management compromises that role.

     

    Moving forward

    Although the challenges caused by a distressed balance sheet can be daunting, recognising the issue and taking action is undoubtedly the best way forward.

     


    This article was originally published in the 2014 Better Boards Conference Magazine.

About Michael Corry

Michael is a finance and governance professional who straddles the commercial and community sectors through a range of skills, qualifications and experience. After work as CFO in a range of businesses, Michael founded CFO Clarity in 2012, providing CFO services to a range of clients. He balances this with several directorships and Chair of Finance roles in diverse non-profit organisations. Michael is a Fellow of the Institute of Chartered Accountants in Australia and also the Governance Institute of Australia. He holds an MA in economics from Christ’s College, Cambridge.

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