Why does insolvency reduce business value?
February 14, 2023
One of the great commercial puzzles is why the unsecured creditors of an apparently healthy business end up only recovering pennies in the pound on their debts and the shareholders get wiped out, if the company files for insolvency.
The bedrock of credit and investment risk management are the annual accounts published by a company. In days gone by, when all accounts had to be audited there was the implied reassurance of an independent opinion on whether the accounts showed ‘a true and fair view’. Broadly speaking, assets were said to be valued at the lower of cost or realisable value.
On the liability side of the financial picture, the balance sheet included crystalised debts and any contingent liabilities were disclosed in some relatively straight forward notes at the back of the back of the accounts.
A succession of financial scandals have tightened the requirement not just to disclose but also to recognise in the balance sheet any liabilities for previously off-balance sheet items, such as pension scheme obligations, leased assets and a myriad of esoteric potential financial risks from such strategies as currency and interest rate hedging. These have been major steps forward, but unfortunately, lobbying by smaller companies has pushed disclosure in the opposite direction by excusing vast swathes of business from having their results audited and drastically simplifying the financial data many have to publish.
Even so, a balance sheet is a balance sheet and ought to provide some comfort to those who trade on credit terms with a business and those who invest in its shares, or at least give them the information on which to assess the risk they are taking.
Going concern valuation
The cost aspect of the asset valuation methodology is simple enough; realisable value is more subjective but capable of verification by reference to independent expert opinions and relevant sale transaction data available in the public domain. What is often overlooked is that assets values are calculated on a going concern basis, or to put it more simply, what they might fetch in a transaction between an unforced seller and a willing buyer.
What happens in a ‘gone concern’?
Once a company has filed for insolvency, its assets will almost always be tainted by market knowledge that the insolvency practitioners handling the case are by definition forced sellers, at least to some extent. Other negative factors can come into play, such as the condition of physical assets if financial problems have meant poor maintenance standards or if the assets are specific to the conduct of the company’s business and cannot be re-purposed for alternative uses. Fixtures and fittings are one obvious example, bespoke IT systems are another. At the same time, the liabilities of insolvent companies tend to balloon for a range of reasons.
You may also be interested in: The hard realities of ‘soft credit’
A real life case study
A high profile retail chain collapsed in 2018, but was then rescued by a competitor, which acquired its trading assets and some of its trading sites. One upside was that most of the jobs were saved, but the story for the other stakeholders apart from its bankers was very different.
The balance sheet in the last published accounts for the main trading company showed the overall financial position some eighteen months before it went into Administration. This revealed total assets of £801m, liabilities of £764m and therefore a net worth of £37m
The Statement of Affairs sworn by the directors after it filed for Administration suggested that at the time of its failure, its total assets had fallen to £657m and its liabilities were down slightly at £714m, meaning that there was a shortfall for shareholders of £57m.
Over four years later, the Administration is continuing, though it is now nearing its end. What has the outcome been? The assets of £657m have realised only £323m before costs, virtually all of which has gone to partially repay the bank, which had priority over almost all other creditors and to pay the costs of the Administration. Unsecured creditors owed £313m will receive around 0.1p in the pound.
How can this happen?
In a series of separate posts, we will look at how and why each main asset class suffers, why liabilities increase and the costs involved in a formal insolvency. The takeaway is that, almost always, a formal insolvency will significantly reduce business value and leave most stakeholders facing heavy financial losses.
Avoiding insolvency proceedings is, then, the ideal objective. But, if that is not possible, then the sooner the insolvency process is started, the less severe the devaluation and the stakeholder losses will be.
If you are seeking professional advice for your business, Opus is here to help. You can speak to one of our Partners who can discuss options with you. We have offices nationwide and by contacting us on 020 3326 6454, you will be able to get immediate assistance from our Partner-led team.