We have already established that directors carry significant personal responsibility for decisions made in the course of directing the company, and the Companies Act, (amongst other legislation) contains various provisions in terms of which directors of failed companies may be held personally liable for losses in the event of the company going out of business. Directors are therefore expected to be especially vigilant and look out for signals indicating that the company could be heading towards a financial crisis.
Sound management reporting and maintaining close contact with the company could alert directors to potential danger.
Some of the more obvious warning signs could be:
Financial
continuing losses or substantial unexpected losses
declining turnover
working capital deficiencies
fixed term borrowings approaching maturity without realistic prospects of renewal or repayment
excessive reliance on short term borrowings to finance long-term assets
denial of usual credit terms by suppliers and other creditors
negative cash flows from operating activities, either historical or projected
adverse financial ratios
significant deterioration in the value of assets used to generate cash flows
inability to pay creditors on due dates
inability to comply with the terms of loan agreements
inability to obtain finance
failure to prepare reliable profit and cash flow projections
inadequate explanations for variances between actual and budgeted performance
recent significant fall in share price
undue exposure to interest and currency fluctuations
Operational
loss of principal customer or supplier
loss of key management without replacement
substantial dependence on the success of a particular project
loss of a key franchise, license or patent
labour difficulties or shortages of important supplies
reliance on a single product or market
resistance to abandonment of a marginally profitable venture
lack of corporate planning
deteriorating customer relations
Regulatory and legal
non-compliance with capital or other statutory requirements
pending legal or regulatory proceedings against the company that could result in claims that are unlikely to be satisfied
changes in legislation or government policy that may adversely affect the company
insufficient review of compliance with a range of legislative requirements
Management
unhealthily close relationship between the chairman and chief executive
dissatisfaction of staff caused by delays in obtaining approvals and decisions
boardroom conflict and indecision
inappropriate management structures
inappropriate filtering of information to the board
decisions taken unilaterally without consulting the board
decisions favour certain interest groups and not in company's best interests
irregular or minimal contact with executive staff
high staff turnover and poor morale
deteriorating relationships between directors and management
Other
auditors identifying significant control problems and disagreeing with management on material issues
negative media coverage of company performance
infrequent review of physical security and insurance
Directors’ role in a failing company
A company that trades while insolvent can render its directors liable to both criminal and civil penalties. Directors can be held personally liable for the debts of a company which, despite being insolvent, recklessly continues trading [§ 424]. This liability extends equally to executive and non-executive directors.
The risk of a director being held personally liable means that directors of a failing company need to make swift and effective decisions and seek professional advice immediately they become aware of a potential crisis.
Key questions:
- As a director am I constantly aware of these indicators of a potential financial crisis, and how should I respond?
