June 2019
Businesses’ future prospects are an important factor in various types of litigation including commercial litigation, personal injury claims involving self-employed claimants and matrimonial cases in which one or more of the parties is a business owner. Loss of profits claims based on continuing losses will generally be computed on the basis of expected future profits and most business valuations will take account of projected earnings.
If a business’ financial statements show that performance has been poor in the past few years, it is unlikely that its prospects will improve as the economy contracts. It is probable, therefore, that legal advisers will take declining financial performance into account in discussing the quantum of such claims in the current economic climate, whether by managing the expectations of claimants or advising defendants that claims against them may be overstated. This newsletter sets out some indicators that send signals to forensic accountants that a business is facing difficulties and that its performance is not therefore likely to improve in the near future.
Basic Indicators
Some indicators of recent problems in incorporated businesses are as basic as a change in a company’s year end, e.g. from 31 December to 31 March. Although this may occur for justifiable operational reasons, it may also indicate that the company was having difficulties in preparing its financial statements. A delay in filing financial statements with Companies House may also be indicative of problems in a company’s finance function. Another indicator may be a disproportionate number of resignations of directors as advised to Companies House.
Assets and Liabilities
Some signs that a business may be in difficulties will be apparent from its balance sheet. For example, the valuations of properties included in fixed assets may be overstated given the recent downturn in commercial property prices generally.
Cashflow is an important indicator of the health of a business. Declining cash at bank and an increasing overdraft compared with previous accounting periods may therefore indicate that the business is facing difficulties. Similarly, the speed with which a business pays its suppliers and collects money owed to it may provide a good indication of its financial condition. In this context, the ratios of creditors to purchases and of debtors to turnover are important: an increase in these ratios over time could suggest increasing difficulties in funding the business’ activities.
Debt levels and debt servicing are often of crucial importance to a business’ prospects. The timing of repayments is potentially significant as a business may be facing the refinancing of large amounts of debt in the current adverse credit climate. Similarly, the notes to the financial statements may indicate onerous future commitments such as obligations relating to capital expenditure.
Turnover and Expenses
An indicator of problems is declining turnover over a period of two or more accounting periods. A continuing decrease in turnover may indicate that the market for the business’ products or services is declining, that its market share and hence its competitiveness is declining, that major customers have ceased to trade or that the business faces production or distribution problems.
A decrease in a business’ gross profit margin over time, especially if combined with high fixed costs is likely to reduce profits over time. Reorganisation or redundancy costs, shown as “exceptional items” in a business’ profit and loss account, indicate that it has been scaling back its activities. The financial statements may indicate whether the business has withdrawn entirely from an activity or whether it has been reducing its capacity in its “core” activities.
Conclusions
It is important to obtain up-to-date information about the financial condition of a business from sources such as management accounts as financial statements may not be prepared for some time after the end of its latest accounting period.
A review of financial statements which focuses on indicators such as turnover, gross profit margin and the cash position is an essential first step towards an overview of a business’ financial performance and position. If the most recent periods for which financial statements are available are characterised by poor financial results, it is important to ensure that all parties realise that calculations of loss or valuations based on the earnings potential of the business in the current climate need to be computed on as realistic a basis as possible.
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The information contained in our Newsletters is provided as general information only. It does not constitute professional advice and should not be relied on or treated as a substitute for specific advice relevant to particular circumstances. In addition, since the Newsletters were published in recent years, the information contained in them may not be applicable at the current time.