Background
Given the increasing risks that companies currently face as a result of sharply rising energy and commodity prices, combined with rising interest rates and declining customer demand, the risk of corporate insolvencies in Germany has increased significantly compared to previous years. So far, this is not yet reflected in the historical trend in the number of bankruptcies. Creditreform reports that “despite the war in Ukraine and its associated effects on the German economy […], the number of corporate insolvencies is remaining at a low level for the time being.” In the first half of 2022, 7,300 corporate insolvencies were recorded. Compared to the same period last year (first half of 2021: 7,510 corporate insolvencies), the number of cases has declined slightly again.” Nevertheless, Creditreform fears that the deteriorating economic conditions will caused by the war in Eastern Europe, supply-side price pressures, and the beginning of a shift in interest rates, that this will not be without consequences for insolvency trends. In this article, we take a closer look at the Ways to Detect a Company’s Insolvency Risks Early and, together with our guest author, Prof. Dr. rer. nat. Alexander Förster, we will discuss selected courses of action available to a company when insolvency risks are identified early enough to safely steer the company through turbulent waters.
Thomas Wirtz is a tax advisor, holds a degree in business administration, and has been the owner of schütze & wirtz Steuerberater I Tax Consultants since 2019. Prior to that, he worked for over 18 years as a management consultant (most recently as a partner/director), with assignments in Indonesia and Australia. Thomas Wirtz is particularly interested in providing tax and financial advice to businesses and individuals, as well as in the digitization of accounting processes.
Early Detection of Insolvency Risks
Companies are confronted with ever-increasing complexity and a growing pace of change in their business environment and must respond more quickly and effectively to new developments. Ideally, weathering a crisis means taking timely action to mitigate a crisis situation to such an extent that it can have little or no negative impact. It also follows from the general duty of care that managing directors must continuously monitor their company’s financial situation; this applies particularly in times of crisis. Managing directors who breach their obligations are liable for any resulting damages. An effective system for the early detection of insolvency requires the existence of a risk management framework. Its purpose is to identify critical warning signs within the company in a timely manner and to take appropriate countermeasures to avoid them or, at the very least, minimize the risks. Selected warning signs of a corporate crisis may include, for example, the following:
- Underutilization of Staff
- Low digital literacy
- Supply Chain Disruptions (Disrupted Supply Chains)
- High dependence on a small number of suppliers and customers
- Building Up Inventories
- Decline in Capacity Utilization
- Losses
- Credit lines that have been fully utilized
- Reduction of credit limits by trade credit insurers
- Delays in Payment
- Products at the End of Their Product Life Cycle
- Declining market share
- Continuous decline in margins
Methods for the early detection of insolvency risks include, among others:
- Traditional balance sheet analysis (asset trends) — balance sheet analysis examines the historical trends of key figures, such as the debt-to-equity ratio and bank balances. The main criticisms of traditional balance sheet analysis are its focus on past performance and its reliance on data as of a specific reporting date. Therefore, additional methods for the early detection of insolvency risks should be used, particularly those that model a company’s future performance.
- Analysis of Earnings Trends (Financial Performance) — An analysis of historical and projected earnings trends reveals whether the company is currently capable of generating sustainable profits and will continue to do so in the future. For companies that are unable to generate sufficient profits, the risk of insolvency increases significantly.
- Preparing a Business Plan: In our view, preparing a comprehensive business plan, updating it regularly throughout the year, and comparing it with actual business performance is a particularly effective method for identifying insolvency risks in a timely manner. When preparing a business plan, it is important that it includes cash flow projections as well as a balance sheet and an income statement. Where possible, so-called scenario or sensitivity analyses should also be applied.
- Mathematical and statistical methods —in practice, mathematical and statistical methods (e.g., multivariate discriminant analysis) are increasingly being used to identify insolvency risks at an early stage.
Options for Action
Structural Measures to Prevent Insolvency
Prof. Dr. Alexander Förster has been teaching Business Informatics in the Department of Economics at Bielefeld University of Applied Sciences since 2017. Prior to that, he served as Head of Corporate Strategy at Wolters Kluwer in Cologne, where he was responsible for digital transformation, and as a strategy consultant at Droege International Group AG.
If an impending insolvency is identified at an early stage, the range of options available expands significantly. While in cases of late-stage insolvency, often only drastic measures ( see below) are effective, in the early stages it is still possible to implement more strategic and long-term measures that are more akin to fundamental optimization efforts. Below, we discuss three such measures in detail:
- The classic option among the available courses of action is workforce restructuring, with the goal of reducing personnel costs. A company’s staffing needs are determined by the tasks and business processes to be carried out and the skills and competencies required for them. A well-founded restructuring measure should therefore always be preceded by a process analysis. A proven approach is to first create a matrix of the tasks to be performed and then have existing employees complete a survey to indicate their individual contributions to the processes. For larger organizational units, appropriate IT-based tools are well-suited for this survey. Based on the resulting analysis, target capacities for individual processes can be determined, and then available capacities for restructuring can be identified. Experienced external consultants typically assist with the process and capacity analysis to maintain a neutral perspective on the company and the individuals involved and to optimally manage the process.
- Another option that also contributes to a company’s long-term success is the optimization of business processes themselves, particularly in light of the opportunities offered by digitalization. Many companies have processes that are highly repetitive and could be automated. One example would be a controller who spends a week every month transferring data from one system to another and making the same adjustments and accruals over and over again. Although it may be partially recognized how inefficient this approach is—and that it frustrates the people involved—there is often not enough time to implement meaningful process optimization using a digital tool. Here, too, consultants with a combination of business and IT expertise can make a valuable contribution: An automated IT tool can be created once and, in the long run, significantly free up staff capacity for other tasks.
- After all, it is possible to improve the cost and cash situation relatively quickly through a procurement optimization project. Even long-established, efficient purchasing departments often fail to realize the full potential for savings that exists in the procurement area. This is frequently due to entrenched structures as well as a lack of time and resources for comprehensive optimization. The first phase of a procurement optimization project always involves a comprehensive data analysis and the categorization of all procured goods and services into material and product groups. Depending on procurement volumes, interdependencies, and other parameters, individual procurement strategies are developed for each material or product group. Possible strategies include, for example, volume bundling, framework agreements, shared growth, cost reduction, etc. Based on the material group strategy, all key supplier relationships are then renegotiated. When such a project is implemented comprehensively, typical savings potential ranges from >10%.
Selected Short-Term Tax and Financial Options
In practice, impending insolvencies are often identified too late. As a result, short-term tax and financial options are often necessary; examples of these are listed below:
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- Reduction in estimated tax payments
- Deferral of tax payments (Exception: The tax office generally does not grant deferrals for sales tax)
- Tax optimization of the tax balance sheet (e.g., special depreciation)
- Extended payment terms for suppliers, debt forgiveness, payment deferrals
- Capital Increase, (Government) Guarantees
- Sell-and-Lease-Back
- Introduction to Factoring
If a company is facing the threat of insolvency and/or has excessive debt relative to its equity, it is strongly recommended to contact a lawyer specializing in bankruptcy law in a timely manner to identify and address legal risks (e.g., delay in filing for bankruptcy, liability risks, etc.).
How can we help you?
Together with its partner, Förster Digital Business GmbH, schütze & wirtz supports digital transformation, process optimization, and cost-reduction measures from a holistic perspective that integrates business and IT aspects to create customized solutions. Our services include, among others:
- Purchasing and Supplier Optimization
- Optimization of working capital, capital structure, and fixed and financial assets
- Tax Optimization
- Negotiations with banks and/or equity investors
Please feel free to contact us.
Sources: creditreform.de
Photos: Gerd Altmann (Pixabay) and personal collection
Disclaimer: We assume no liability for the accuracy and completeness of the information. The information provided here does not constitute recommendations for action.
