How can a profitable company go broke? (Profit into cash to avoid failure)
How to go broke while making a profit
If your reason for searching out the question about a profitable company going broke, this article offers-up a few solutions to the reasons why companies often go broke despite making a profit. But how can a profitable company go broke? Let’s take a look…
How can a profitable company go broke in 15 seconds…
Even profitable businesses can go broke if the cash flow is not sufficient to continue trading. There are many reasons why certain profitable companies can go under. This can include what’s termed over-trading or simply because the business fails to collect money due from customers in a timely fashion. Whether a business survives or not is dependent on the way the business operates and manages its finances. If management don’t operate correctly, the business could end up in bankruptcy.
How can a profitable company go broke?
There are a number of reasons why a profitable company can go broke. These are a few good reasons why profitable businesses end up going bankrupt:
- Over trading is one of the top reasons why companies go broke even when profitable.
- Failing to collect amounts due from customers.
- A failure to meet liabilities as they fall due, which includes bank finance and loans.
- Banks calling in loans where covenants are breached.
- Banks changing how they offer finance to a particular industry.
- A significant bad debt.
- The occurrence of a significant global event like Coronavirus or Covid-19.
- Failing to plan or prepare forecasts for the business.
Let’s now take a look at each of the reasons why businesses fail or go broke even when they are making a profit.
1. Over-trading can cause a profitable company to go broke
Overtrading usually arises as a result of not having enough working capital in a business. Or put another way, the business simply runs out of cash. The phrase or saying “cash is king” is one of the fundamentals of any healthy business.
Overtrading often occurs when companies expand operations too quickly or aggressively. If you are chasing sales, whilst not chasing the money at the same time, you could wind up running out of cash and going broke.
Overtrading or running out of working capital is more likely to happen if your business has significant cost of sales. This is even further exacerbated when credit terms to customers are not in balance with the credit terms you have with your major suppliers.
An imbalance in credit terms between your customers and suppliers
For example, let’s say for whatever reason your business offers 60-day payment terms to your customers. But on the other-hand, your major suppliers offer 30-day payment terms. Or worse still, payment terms are to pay before delivery or cash on delivery.
If the sales are increasing month-on-month to such an extent that the timing when cash is received vs the timing when money is paid out reaches a point where cash simply runs out.
If you don’t have enough working capital (or cash in the bank), in these circumstances the business will fall over. Unless extra funding is sought to cover the cash flow short-fall, the business will go broke. This would be despite making a profit. In this case the cash flows are not keeping up with the profits being made.
Solutions for overtrading businesses
The best solution to avoid this situation in the first place is to prepare cash flow forecasts. Before you get to the situation where you run out of cash, you can prepare what-if scenarios. You’ll be able to model various options or sales growth vs customer and supplier payment terms beforehand.
Having cash flow forecasts will allow you to calculate the level of working capital required, before you run out. Banks and investors are more keen to lend or invest to businesses where the owner or directors plan ahead.
Other solutions to over-trading
Other solutions to overtrading include: Changing the credit terms offered to your suppliers or requesting better payment terms from your major suppliers; or both. Alternatively, you could seek additional finance from your bank to cover the working capital shortfall, be this in the form of a long-term loan or by asking for a bank overdraft facility.
Apply for a facility for invoice discounting or factoring
If you are not able to get better payment terms from your customers. Or if you are unable to negotiate longer credit terms with your major suppliers, you could resort to invoice discounting or factoring. However, be warned that factoring your trade debts can be expensive. But also read reason five below about why businesses fail even when profitable.
If you ‘d like to plan for using factoring and to understand your cash flows with this facility in place, you may want to run what-if scenarios with cash flow forecasting software that includes this factoring or invoice discounting functionality.
2. Failing to collect amounts due from customers
Many business owners make this mistake and fail to collect receivables in a timely manner. Often times business owners boast about the turnover of their business, but without necessarily focusing on what’s more important, i.e. profit or cash.
As already mentioned above, cash is king. It’s almost pointless invoicing customers if you fail to collect what they owe. If your business is making profits, but the profits aren’t being banked, you’ll soon run out of cash.
Solution for businesses that fail to collect customer debtors
There are a few steps you need to take, as well as a few systems you need to implement in your business to improve cash collections, these are as follows:
- Employ an external or an in-house credit controller or debt collector to enforce your payment terms.
- Change you payment terms to a shorter period.
- If customers breach their credit limit, make sure to put a stop on further supplies of service or delivery of product until the account is brought into line.
- If customers fail to pay on time, this is another reason to put their account on hold.
- Communicate with customers on a regular basis with statements and chaser letters to enforce the amounts due.
- Make it easy for customers to pay by including payment details on your invoices. The number of times I still see businesses that fail to do this is still too often.
- Making it easy for customers to pay could include offering more payment solutions, like offering to pay by cards or credit card.
3. A failure to meet liabilities as they fall due, which includes bank finance and loans
Failing to mean liabilities as they fall due could be a symptom of overtrading or failing to collect amounts due from customers on a timely basis.
To run a business as a going concern, you must pay amounts due on the due date. Otherwise the supplier or bank will take steps to enforce the debt.
If you have a bank loan there are strict rules about payment terms. If you miss a loan repayment your business will be in default. Default of loan payments and you could face enforcement action, which can include a winding up petition.
Solutions where you are failing to meet liabilities as they fall due
Of course the simplest solution to avoiding enforcement action is to pay amounts owed when they fall due. However, if you don’t have the cash in the bank to cover these liabilities, this may be a problem. So what’s the answer? Here are a few possible solutions:
- Ask for time to pay.
- If the late payment relates to a bank loan, speak with the bank concerned. Ask for time to pay, but also ask for a payment holiday. Seek new payment terms or a restructuring of the loan.
- Look for alternative sources of finance to cover the shortfall. But with this in mind, you will need to prepare a business plan, supported by a cash flow forecast. You want to know yourself whether the business can weather the storm, and a cash flow forecast will help to demonstrate that. Don’t just think the business plan and cash forecasts are for the bank, they are for you too.
4. Banks calling in loans where covenants are breached
Bank loans to businesses will have certain covenants attached. Common metrics used by lenders as debt covenants include the following:
- Debt to EBITDA (Earnings before interest, tax, depreciation and amortisation.).
- Interest cover – i.e. how many times the loan interest is covered by profit. This can be EBITDA or EBIT (Earnings before interest and tax).
- Debt to equity.
- Debt to assets.
- Business net worth or balance sheet total.
- Dividend thresholds.
- Timely management information and final year end accounts supplied to the bank.
Solutions where your business has breached or is about to breach lending covenants
Changing covenants with lenders isn’t an easy task. It’s true what they say about banks, they offer an umbrella when the sun is shining. But when it’s poring with rain, there’s no umbrella in sight on offer!
This is true of covenants too. But control those covenants that are easier to control. Like providing up to date financial information. Don’t stick your head in the sand if on paper one of the covenants has been breached. You are far better to provide the information on time, but go with a solution. If you have one that is.
If one of the covenants includes no further lending, don’t borrow more without first speaking to your current lender. However, the alternative to this would you seek alternative lenders to access more finds, but sufficient to cover the working capital shortfall, but also enough to repay the original debt. Easier said than done, but a better approach than sticking your heads in the sand.
5. Banks changing how they offer finance to a particular industry
You may or may not be surprised to learn that banks can and do change their mind about which industries they will lend to. Be warned, banks that change their minds can do so quick quickly. But also, they don’t always take the view that they will allow the existing loans to remain in the industry from which they have withdrawn.
A friend of had a very profitable business making doors for buses. To fund the working capital, his business used invoice discounting. However, the bank concerned decided they no longer supported the transport industry. As a result they called in all loans. In my friend’s case, his borrowing totalled circa £500,000, and I think from memory the bank gave him a month to repay this debt.
This is a case in point how a profitable company go broke, which is what happened.
Solutions to banks changing how they offer finance to a particular industry
This isn’t an easy one. As you can imagine if you have business borrowing and the bank concerned comes to you for a total repayment simply because they’ve change their mind becomes an almost impossible situation.
You are relying on finding an alternative bank to provide the lending. But not only that, often times in a very short time scale.
One piece of advice I level with you is to have bank accounts with several of the major banks. That way your business builds a working relationship with each of those banks.
Also, where possible and if you are able to borrow from more than one lender without breaching covenants, as per point 4 above, I suggest you spread your lending across more than one lender.
6. A significant bad debt can lead to a profitable company going broke
What many business owners don’t realise until they have a significant bad debt is the double hit that happens. When you suffer a bad debt you not only lose the money that’s owed to you at the time the customer goes broke, but also you lose the ongoing sales to that customer too.
Solutions to avoid significant bad debt
How to avoid significant bad debt is to introduce all or some of the following:
- Debt insurance: it is possible to insure your trade debtors. However, this insurance isn’t cheap and often comes as part of a package when you factor your debts.
- Factoring: If you factor your debts you often have a more robust collections system in place, which
- Tight credit control: Having a good credit control system in place will help you to avoid a significant build up of customer debt. See point 2 above.
- Credit check your customers: Credit checking your customers will help to avoid supplying to businesses that are more likely to go bust.
- Avoid reliance on one or a few customers: If your business has a heavy reliance on one or a few significant customers, if one of these customers goes broke this could cause your business to go bankrupt too.
- Change to pay before supply or money upfront: If you have all your money upfront before you supply products or services you’ll never have a bad debt in the first place.
Very relevant as I write this article that the whole world is suffering as a result of a world pandemic. Coronavirus or Covid-19 is causing havoc around the globe. There will be many profitable businesses that may go bust during the course of the Covid-19 pandemic.
Despite the fact that governments from around the world are offering up support to businesses, there will inevitably be many that will go bust. Schemes in the UK such as the government’s Coronavirus loan scheme. There’s also the furloughing staff scheme in the UK where the government has offer to pay staff up to 80% capped at £2,500, which is unprecedented.
However, despite these schemes, if the companies concerned don’t have sufficient working capital to get them through the pandemic, they may not survive and go bust.
Many small businesses owners are struggling to get access to loans from the government’s Coronavirus loan scheme. Some are not willing to take on the added risk of this scheme and may let what would otherwise have been a profitable business go bankrupt and liquidate.
If you are in the middle of trying to sort out how your business survives Coronavirus, this will no doubt be extremely challenging. I can mostly focus on businesses in the UK, as I know this system better. But where appropriate follow this guidance using the schemes or help that your government is offering.
Seek bank funding to fill the gap: Having enough cash in the bank or sufficient working capital will be critical to get through the Corona virus pandemic. I suggest you prepare a cash flow forecast and create a business plan for the period of shut-down. Whilst it’s difficult to know exactly how long this will go on for, you should plan for the worst, but hiope for the best.
If for example you borrow too much from the bank and end up with excess funds when things go back to normal, you will be able to use these excess funds to pay down the borrowing.
However, on the other hand if the lock-down goes on for longer than you plan for, this will cause you problems. I therefore suggest you use the worst case scenario to borrow, but hope things don’t go on for that long.
So long as your business was profitable beforehand, and is likely yo be the same post-Coronavirus or Covid-19, there’s no reason to suppose you’ll not have the future cash flows to repay any extra borrowings.
8 Failing to plan or prepare forecasts for the business may result in a profitable company going broke
Many of the sections so far in this article have made reference to planning and preparing cash flow forecasts. But as this is particularly important, I thought it deserved a section on its own.
There’s a good saying, which is “if you fail to plan, you plan to fail“. Business planning is a key part of any successful and profitable business. For example, as explained in the section of overtrading, it can be seen that overtrading is often as a result of planning and forecasting beforehand.
Using cash flow forecasting software to run what-if scenarios before you start your business, or before you loo to expand, may be enough to prevent the problems that can be caused by over-trading.
- The ability to change payment credit terms on customer payments.
- Being able to change the suppler credit terms.
- Review what-if scenarios of taking on factoring or invoice discounting.
- Run what it scenarios with reduced sales or increased costs.
- Forecasting borrowing from banks and how this affects future cash flows.
- How capital expenditure affects future cash flows and working capital requirements.
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