Go to on Insolvency and its sister discussion and questions page then read what follows.

The BBC Working Lunch pages on Insolvency are pretty good: the example they take us through and the additional questions they ask give the student a good introduction to insolvency, why it might happen and some of the things that might be done about it.

However, this page takes a closer look at a few aspects of insolvency that will enhance students' knowledge even more. The BBC Working Lunch pages on Insolvency discuss a company called Just Tyres; and we will use this company here from time to time.

The BBC Working Lunch pages are suitable for all levels; but this page is probably more appropriate to A level Business Studies and Accounting and Undergraduate Business Studies and Accounting rather than GCSE level.

The issues we'll discuss here are

• Overtrading
• A definition of insolvency
• A discussion of
  • bankruptcy
  • liquidation
  • receivership
• A discussion of
  • operating gearing
  • financial gearing
• A discussion of the impact of the incidence of fixed costs on the break even point

Overtrading

Overtrading is associated with businesses that are growing or changing too quickly. They take all forms of risks and they take all forms of finance in an effort to grow. A good indicator of overtrading is the Current Ratio (Working Capital Ratio) this will be too small showing that it has a lot of short term debt relative to its stocks, debtors and cash.

Many businesses start out with some sort of plan, and if they find themselves growing quicker than expected, the natural reaction is to try to cope with everything; and this is where the rot sets in. Businessmen often chase the sale without considering the consequences of it: profitability, implications for cash flow, fixed assets that need to be used/bought to cope, the impact on employees and the wage bill … maybe extra overtime is needed.

There's a good example of the effects of overtrading if you need a worked example to explain exactly what can happen. This story concludes as follows:

If you do not take this new work, future work with this company would probably revert to small jobs, if anything. If you do take the job, you are unlikely to survive because this increase in business is out of your control, and not based upon a sound financial plan ...

… there's more to this and it's well worth a read.

Questions:

1. Which financial ratios would you use to identify overtrading?
2. How can you tell that the answers you get from the ratios reveal overtrading or not?

Insolvency and Bankruptcy

So what exactly is insolvency and what is bankruptcy?

Insolvency

Insolvency is defined as having insufficient assets to meet all debts, or being unable to pay debts when they are due (see The Insolvency Service of the UK Government)

There must be many times when we don't have enough money to pay for the petrol we need or the bus fare home; that makes us insolvent according to the definition.

Bankruptcy takes a longer term view of being a cash free zone than insolvency does. In other words, to be considered bankrupt, we need to be in the state of not only having enough cash, but of having no prospect of getting the cash!

Moving directly on from insolvency we have to distinguish between the operating and financial aspects of costs and capital structure. We discuss these matters because Just Tyres has shown us the importance of considering the type of finance we get involved with.

Operating and Financial Gearing

Financial gearing

Financial gearing relates to the ratio of the long term finance with a fixed interest charge, such as debentures and preference shares, making up a company's capital to its ordinary share capital. A company is said to be highly geared when it has relatively more fixed interest capital than ordinary share capital; and it is low geared when its capital is predominantly in the form of ordinary shares. The extent of an organisation's gearing is seen best when we compare similar companies.

Operating gearing

Operating gearing relates to having a large proportion of fixed costs relative to total costs: the higher the extent of an organisation's fixed costs, the greater its operating gearing: Just Tyres suffered from high operating gearing because they had high fixed costs associated with the rent of their premises: they also had a lot of equipment and machinery as far as we can tell.

We will talk about this when we consider break even points and cost structure.

Bankruptcy, Liquidation, Receivership

Bankruptcy relates to individuals and not organisations: so, I can be declared bankrupt as a result of making a mess of my personal financial affairs; but that will not necessarily affect my business life. If I am declared bankrupt then I am adjudged to have a long term financing problem and I will have a court order made against me that will mean that all of my assets will be looked after by the Official Receiver … except my tools if I am a plumber or electrician for example, my books if I am a lawyer or teacher and my car if I need it to carry out my work.

Liquidation

Liquidation means that a company ceases to exist and there are three types of liquidation:

• Members voluntary liquidation: the company liquidates but it is expected that the creditors, employees, taxes and shareholders will all be paid any money owing to them. An insolvency practitioner will carry out this liquidation.
• Creditors voluntary liquidation: it is expected here that the company cannot pay all of its bills, so a meeting of creditors is held to discuss the liquidation of the company and an insolvency practitioner carries out the liquidation.
• Compulsory liquidation: here, a creditor creates an action against the company where it is clear that a debt cannot be paid: providing the debt is at least £750.The grounds on which a company may be wound up by the court include: a special resolution of the company that it be wound up by the court; that the company is unable to pay its debts; that the number of members is reduced below two; or that the court is of the opinion that it would be just and equitable for the company to be wound up. Insolvency pratctitioners are clearly involved here.

Who gets what?

The most common form of liquidation is the voluntary form: either by members or creditors. Perhaps most importantly, though, there is a pecking order of who gets the spoils after a liquidation:

1. Fixed charge holders: eg mortgages, debentures, hire purchase agreements
2. Preferential creditors: Customs & Excise, Inland Revenue, National Insurance
3. Floating charge holders: eg creditors for stocks and work in progress
4. Unsecured creditors: everyone else who is owed money
5. Shareholders: ordinary shareholders

Receivership

This is the process that Just Tyres is going through at the moment.

When a company is in receivership, it is managed by a Receiver whose job it is to sell the company as a going concern, having made the company as attractive as possible.

The pecking order of who receives money following receivership is:

1. Fixed charge assets are liquidated and the money owing to the fixed charge holder is paid to them: any surplus goes to the liquidator;
2. Floating assets are liquidated and the money owing to preferential creditors is paid in full before the debenture holder receives any payment.

A Receiver is really a manager who has superior powers to the company management. After all, we saw with Just Tyres that the Receiver was able to get rid of rental agreements and so on whereas the company management simply couldn't. Just Tyres was also facing having to make redundancy payments to employees and this is a cost it was dreading to have to face.

Questions

1. What are the laws governing bankruptcy and insolvency in England & Wales (what's wrong with Scotland?)?
2. Where is a bankruptcy order made?
3. Who deals with bankruptcy cases?
4. Who can appoint a Receiver?
5. What are the powers of a Receiver?
6. What does the phrase going concern mean?
7. Who can be a liquidator (apart from Darth Vader and Rambo!)

Activities

• Go to The Insolvency Service of the UK Government and read through their glossary of insolvency terms and their FAQs.
• Find the Official Receiver nearest to you … you never know!
• Find out why directors might be disqualified from being directors.

High Fixed Costs and the Break Even Point

Just Tyres is probably a victim of overtrading and of high operating gearing: maybe also high financial gearing; but I could not get at their financial reports to verify this. I tried to access their records at www.justtyres.com only to find that it didn't exist any more … a fixed cost done away with no doubt.

Let's keep the discussion general, therefore, by comparing a low operating gearing company with a high operating gearing company on the following graphs:

Taking extreme cases just to illustrate the point, the low fixed cost organisation has very low fixed costs and a very low break even point.

The high fixed cost organisation on the other hand has very high fixed costs and an almost impossibly high break even point.

The extent of Just Tyres' fixed costs profile can be seen in part when we learn that of the 92 outlets that Ernst & Young reveal them to have, 90 of them are leasehold, requiring rent payments.

Question:

1. Find the financial results of a variety of organisations (eg a factory, a bank, a haulage company) and plot them on a graph: are you dealing with a high fixed cost organisation or a low fixed cost organisation?
2. Say why you are or are not surprised by the results you have found
3. Ernst & Young have some of Just Tyres' financial information on their web site … find it!

   Additional Resource

   For more advanced students, there's a useful page that answers the questions of what a company can do to improve profits if it suffers from:

   • High fixed costs
   • Low variable costs
   • Fairly fixed capacity
   • Highly competitive marketplace

   Duncan Williamson
   28 October 2001 corrected 30 October 2001