The manufacturing industry in Australia has faced an array of challenges, notably, technological disruption and global competition. While many manufacturers have seen a decline on their balance sheets, this shouldn’t be the end of an era, but an opportunity to do a ‘one-eighty’ and achieve growth, writes Garth O’Connor Price of William Buck.

According to the Australian Index Group, the next two-year forecast for the manufacturing industry is predicting growth. On the back of this forecast, businesses that have seen a downturn in results should look to seize this opportunity to turn their business around.

The Government is making headway to allow manufacturing to flourish and evolve in Australia through grants and the Research & Development (R&D) Incentive. Furthermore, to promote innovation, the introduction of Safe Harbour Legislation creates a safety net for entrepreneurs to fail – if they act in good faith – and removes the historical stigma attached to insolvency.

Prior to the introduction of Safe Harbour, entrepreneurs facing risk of insolvency only had the option of a Voluntary Administration (VA). Safe Harbour acts as an alternative to VA; parking the risk of personal liability by providing an insurance policy for directors to seek advice and safely engage to restructure. For manufacturers who are impacted by eroding profits, Safe Harbour is an important first step to achieve a genuine turnaround and avoid personal liability.

Am I heading towards insolvency?

Insolvency is defined as not being able to pay debts as and when they fall due. Factors considered as part of a solvency assessment include:

  • Availability of liquid assets. Liquid assets are cash and those assets that can be readily converted into cash without effecting the value received (i.e. accounts receivable). Inventory can also be considered a liquid asset in the normal course of business; however, if a company is forced to sell inventory to generate cash flow it may affect the value received for the inventory. Non-liquid assets can include real property, plant and equipment and intellectual property and are rarely considered in a solvency assessment as they cannot be converted into cash in a reasonable period, without affecting the value or disrupting a business’s operations. It is for this reason that a company may have a positive net asset position on their balance sheet but may still be insolvent.
  • Funding secured from outside of the company. Overdrafts, equity redraws, asset finance and related party funding can form part of the liquid assets available to pay debts when they fall due; however, there must be some form of binding commitment for the company to rely on to form part of the pool of available assets.
  • Are debts due and payable? The commercial reality of creditors indulging their debtors by informally extending credit terms should be considered; however, written agreement on deferral or forbearance should be sought if it relates to a material debt to the business. On the other hand, a debtor’s simple refusal to pay a debt is not always a clear sign of insolvency if they are refusing to pay due to a dispute or because they willingly want to frustrate the creditor. Claims are not considered when assessing the solvency of a company. A classic example of a claim is a creditor pursuing unliquidated damages for breach of contract. The claim would only become a debt once a precise amount for the breach is calculated and agreed upon (either via settlement or court judgement).
  • Future / contingent liabilities. Future and contingent liabilities should also be considered in a solvency assessment. Future lease payments (committed to under a lease contract) is an example of future liabilities and an obligation to pay an amount at a future date if an event occurs (i.e. providing a guarantee) is an example of a contingent debt. It should be noted that onerous contracts can drain a company’s cashflow and a business restructuring or turnaround may create an opportunity to revisit these poor performing contracts.

Lessons from a sliding doors moment

A recent engagement at William Buck with a textile manufacturer highlights the difference in approach pre- and post-Safe Harbour, but more significantly offers five key takeaways for manufacturers, in what can be described as a ‘sliding doors moment’. A period of trading losses had eroded the manufacturer’s balance sheet, which had in turn been propped up by related-party funding to maintain the company’s solvency.

Our initial meeting (pre-Safe Harbour) was to consider whether a formal insolvency appointment – or VA – was an appropriate remedy to the company’s financial difficulties. The focus of a VA to protect a company that’s insolvent or on the verge of insolvency to allow for an assessment of the company’s balance sheet issues and assess whether a restructure of the balance sheet is possible.

A VA could lead to compromising current debt to a level manageable for the company and assisting the company in rectifying the profitability of its business. The director was concerned with the perceived stigma of entering into a VA and opted to go it alone with respect to addressing the company’s balance sheet issues.

Fast forward to post September 2018, and the option of restructuring a company outside a formal insolvency appointment while maintaining protection from insolvent trading action was made available with the Safe Harbour Reform.

The What-If? – Applying the conditions of Safe Harbour

Safe Harbour gives protection from insolvent trading claims (made against directors personally) where a genuine turnaround plan is being undertaken that is reasonably likely to lead to a ‘better outcome’ for creditors, than if a winding up was to commence immediately. Protection is available for directors that engage with an appropriately qualified advisor to monitor that turnaround and adhere with their director’s duties. These include acting with due diligence and care, and not placing their own interests ahead on the company’s.

This can be a difficult balancing act. With 95% of manufacturers in Australia being small businesses with 20 people or less, many often have personal assets on the line – either directly, through secured lending against personal assets, or indirectly through the risk of insolvent trading claims.

They must also maintain employee and taxation obligations by keeping them up-to-date. It is common practice for companies struggling with cashflow to use their employees and ATO as a form of banker by withholding superannuation, PAYG and GST that won’t necessarily affect trading in preference for paying critical suppliers that could affect operations if supply is stopped.

Manufacturing-specific turnaround initiatives

Once Safe Harbour is initiated, there are industry-specific strategies that can aid in a manufacturers turnaround. While there isn’t a one-size-fits-all approach when it comes to a turnaround, common initiatives will include:

Improving products: The Advanced Manufacturing Growth Centre (AMGC)’s recent report shows that when it comes to R&D, Australians are doing less than their global competitors. Prior to Safe Harbour, the absence of this safety net historically stifled research & development. Investing in R&D is a viable option for manufacturers to future-proof profitability. The protection of Safe Harbour will allow a director to incur debt in the development of new or improved products, even if there’s a risk of insolvency. Furthermore, manufacturers that also embrace robotics and automate some processes may decrease the labour costs from their businesses.

Diversification: This may include diversifying product lines, customer base, supply chain and geographic servicing. The AMGC report found that many Australian manufactures are domestically focused. As an example, manufacturers can take advantage of reshoring some production, becoming export-orientated, or building global partnerships along the value chain.

Creating flexibility in cost structures through initiatives such as workforce realignment from employee-based to contract-based (where applicable) and increasing the scalability of manufacturing processes. In doing so, when demand decreases they can be manipulated to reduce unnecessary costs. This initiative is important as the Australian Index Group has flagged an increase in the growth of input costs for manufacturers resulting from disruption in the energy and agriculture sectors.

Making the wrong decision has serious consequences

In our example, the director decided against utilising a formal insolvency framework to address balance sheet issues and determined that he could rectify the profitability issues himself. He decided to refinance against personal property to inject working capital into the business – which can be a short-term strategy if the underlying problems of the business are not rectified, and can exacerbate the problems for the company and director in the longer term.

The swapping debt for debt was proven to be a band-aid fix; 10 months later, with the profitability issues still plaguing the business and continued losses continuing to erode the balance sheet, the company had no choice but to appoint a VA when related party funding was ceased.

The result for the company was a liquidation of its assets (at a significantly discounted value) and the termination of its workforce. This was because no party had been willing to propose a compromise to creditors or purchase the business because of the damage done by months of unprofitable trading due to the deterioration of relationships with key suppliers, diminishment of the company’s brand due to poor quality control of products, and disruption of supply for customers.

This left the director exposed firstly to personal guarantees to secured creditors and trade suppliers and an insolvent trading claim from the liquidator and potentially other creditors. In the post-Safe Harbour era, the Director could have avoided personal liability with a process that is simple to implement with good advice.

Key takeaways

  1. Early intervention is critical.
  2. Seek advice from a qualified insolvency professional.
  3. A head in the sand approach does not work.
  4. There is protection available, even if the plan doesn’t work, as long as the attempt is genuine and there is a reasonable chance of success.
  5. Turnaround can be achieved without stigma of formal insolvency event.

If you are unsure of your position, William Buck is able to offer a free informal assessment that will review your position and whether Safe Harbour is a viable option.

www.williambuck.com