Monday, July 13, 2009

How to Know a Company That Will Soon Wind Up - The Going Concern Concept

How to Know a Company that will Soon Close Down – The Going Concern Concept

Ever before the recent global financial meltdown, some companies were forced to close down due to factors not within their control. Whether the External Auditors of these companies had given them clean bills of health is an issue for another discussion. As a follow up to my previous article on How to Interpret the Financial Statement of a Company, there are symptoms that create doubt as to a company’s ability to continue in business or otherwise. Once these symptoms are spotted or seen in a company, it becomes risky and a matter of personal decision to continue investing in such companies. This article does not however suggest that the presence or absence of these symptoms will translate to the winding up of a company.

The going concern concept assumes that the business unit will operate in perpetuity; that is, the business is not expected to be liquidated in the foreseeable future. A business is considered a going concern if it is capable of earning a reasonable net income and there is no intention or threat from any source to curtail significantly its line of business in the foreseeable future. In addition to understanding how to interpret the financial statement of a company, it is advisable to conduct due diligence questions before investing into a company.

The above notwithstanding, the presence of the following symptoms may indicate the going concern difficulties in a company:

1. High or increasing debt-to-equity ratio – high gearing.
2. Loan repayments are falling due in the near future, and re-financing facilities are not available.
3. The company is heavily or increasingly dependent upon short term finance, especially on trade credits and bank overdrafts.
4. The company is unable to take advantage of discounts; the time taken to pay creditors is increasing and suppliers impose cash purchase terms.
5. Normal purchase are deferred thereby reducing stocks to dangerously low level.
6. Reducing profitability levels or substantial losses are occurring.
7. Capital expenditure is being replaced with leasing arrangements.
8. The company is in an exposed position in relation to future commitments such as long term assets being financed by short or medium term borrowings.
9. The company’s ratio of current assets to current liabilities is declining or even has a net deficiency.
10. Collection rate of debtors is slowing down.
11. The company is near its present borrowing limits, with no sign of a reduction in finance requirements.
12. Rapid development of business is in danger of creating an over-trading situation.
13. There are substantial investments in new products, ventures or research, none of which has been successful.
14. The company depends upon a limited number of products, customers or suppliers.
15. There is evidence of major reductions or cancellations of major capital projects.
16. There is heavy dependence on overseas holding company for finance or trade.
17. Heavy dependence on imported raw materials and components in a regime of continuing depreciation of local currency.
18. Disruptive work force or high labour turnover in specialized industries.
19. Continuing disputes among those charged with governance.

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