The Covid-19 pandemic and the cost of living crisis that immediately followed have caused many businesses to fall into insolvency. The total number of company insolvencies registered in 2023 was 25,158 (seasonally adjusted), the highest number since 1993 and 14% higher than in 2022. In addition, the number of company voluntary liquidations (CVLs) in 2023 was the highest since records began in 1960.
To protect your business and ensure you comply with relevant sections of the Insolvency Act 1986 and company directors' duties, it is vital to understand your customers' insolvency risk and manage any risk your organisation poses to its creditors.
What is Insolvency Risk?
Insolvency risk (also known as bankruptcy risk) is the risk that a business will not be able to meet its payment obligations within a time period (typically 12 months).
Insolvency risk can result from:
- Poor cashflow management
- Too much expenditure
- Catastrophic events such as pandemics, wars, and severe recessions
Another major cause of insolvency risk is the collapse of a large customer. An example of this was the liquidation of construction and facilities management giant Carillion which resulted in over 30,000 businesses throughout the supply chain being hit with huge financial losses. In October 2018, a few months after Carillion's collapse, a report from accountant Moore Stephens said there was a 20% spike in the number of UK building sector firms becoming insolvent. This type of insolvency situation is known as the 'domino effect,' due to the failure of one business often leading to others meeting the same fate.
Although less common, the insolvency of a supplier can also result in a domino insolvency in cases where the goods supplied are difficult or expensive to obtain.
What is Business Insolvency?
Business insolvency is when a business is unable to pay its debts. There are two ways to measure whether a company is insolvent:
- Cash Flow Insolvency - occurs when the company does not have enough cash to pay its invoices and loans. On paper, the business may seem fine, i.e., it has valuable assets, but the company is poor in terms of cold, hard cash.
- Balance Sheet - where an organisation's liabilities outweigh its assets. Liabilities include all debts, payments and money owed to creditors, ranging from utility bills and mortgages to wages, pension payments and taxes. Assets will consist of everything with capital value, including vehicles, property, equipment, hardware, trademarks, machinery, and computers.
If a business becomes insolvent, the following may happen:
- A Company Voluntary Agreement (CVA) may be proposed.
- An Administrator may be appointed to decide how to ensure creditors get paid. Options include allowing the business to trade out of insolvency or to sell it as a going concern.
- A floating charge holder, normally a bank, will appoint an Administrative Receiver to recover its money.
- The company is put into liquidation (also known as winding up).
Why Do Businesses Fail? Understanding Business Insolvency Risk
The reasons for business failure are many, but below are the most common:
- Cash Flow Problems – customers paying late or not paying at all can send even the most profitable business to the wall. It does not matter how great your sales pipeline or invoice book looks; if you are not getting paid, you will quickly get into financial strife.
- Expanding Too Quickly – the faster a business grows, the bigger the risk it will go bankrupt. Expansion is expensive and can negatively impact your cash flow.
- Reliance on One or Two Customers – although it can make life easier in terms of customer care and administration if one or two customers provide a substantial portion of your turnover, you risk domino insolvency if they collapse.
- Recession – tough economic times can result in even the most profitable businesses becoming insolvent if they have not implemented an emergency plan for such an event.
- Bad Decisions and Lack of Research Before Launching – often, the seeds of failure are planted before a business opens its doors. For example, you may dream of running a vegan café, but if you live in a rural farming area with few young people around, you might want to re-think your offering.
How to Assess Your Insolvency Risk
Paying attention to your business is key to understanding if it is at risk of insolvency. Warning signs to look out for include:
- You have lost or are at risk of losing a significant customer
- You are finding it harder to pay your invoices on time
- Your current sales pipeline is drying up, and customer retention is falling
- Key personnel have resigned
- You need to take out loans to meet your business overheads
- Your organisation is receiving bad reviews
You can use liquidity ratios to determine if you can pay your debts without raising external capital. Liquidity is the ability to convert assets into cash quickly and cheaply. Liquidity ratios also provide insight into how much buffer you have in your cash flow.
How Do I Identify Customers Who Are at Considerable Risk of Insolvency?
You need to continue monitoring and evaluating your customers if you want to understand their insolvency risk. Below is a list of red flags. The more times you answer 'yes' regarding a particular customer, the greater the risk of it going bankrupt.
- Is it taking longer for the customer to pay invoices?
- Have they approached you to renegotiate existing contracts?
- Are deliveries becoming late or erratic?
- Are disputes developing?
- Have they taken out loans?
- Have they recently lost a major client or supplier?
- Are they attracting negative press coverage or getting bad reviews?
- Have there been a wave of senior employee resignations?
- Have they appointed restructuring advisors?
What Sectors Are Most Vulnerable to Insolvency?
Trading in particular market sectors can increase your risk of your business becoming insolvent. For example, following the 2008 financial crisis, banks and other lending institutions required Government bailouts to stay afloat. However, following the cost of living crisis, in 2023, the five industries in England and Wales that experienced the highest number of insolvencies were:
- Construction (4,371, 18%)
- Wholesale and retail trade; repair of motor vehicles and motorcycles (3,929, 16%)
- Accommodation and food service activities (3,727, 15%)
- Administrative and support service activities (2,299, 9%)
- Professional, scientific, and technical activities (2,001, 8%)
Examples of well-known brands that have recently folded include:
The Vampire's Wife
Despite being worn by the Princess of Wales and Natalie Portman, the company went into administration in July 2024.
The Body Shop
The UK health and beauty success story has recently been bought out of administration.
Party Pieces
Owned by the Princess of Wales's parents, Michael and Carole Middleton, the party supplier fell victim to Covid-19 in 2023 with debts totalling over £2.5 million. Teddy Tastic Bear Company Limited acquired the company in June 2023.
How Can I Manage My Insolvency Risk?
Under the Companies Act 2006 and the Insolvency Act 1986, company directors must keep a strict eye on how the business is doing financially and act if there are warning signs that the company may become insolvent.
The 'cash flow test' and the 'balance sheet test' are your primary tools for managing your organisation's solvency. To monitor these effectively, you need to:
- Review management accounts monthly
- Have a rolling 13-week cash flow forecast
- Meet frequently with your CFO and have them present regular updates so all C-suite members understand the business's financial position
- Regularly examine key financial ratios, particularly the current and quick ratios
- Keep detailed records of all board decisions relating to company finances
It is possible to obtain B2B trade credit insurance to provide protection if one of your customers becomes insolvent. However, the best protection is to understand your customers, suppliers, and your own organisation's insolvency risk and put risk management strategies in place to protect your best interests.
How We Can Help
If you are in financial difficulties and facing insolvency, we can offer you clear, practical legal advice on how to navigate the law relating to debt recovery and comply with your legal obligations. Contact us on 0330 173 6983 or send us an email for more information.
