When profits are not the answer

“Profits are not the answer” sounds like one of those statements made before adding, “said no one ever!” There is truth to the comment, though. The time when profits are NOT the answer is when you are using future profits to prove the company is currently solvent. Specifically, a plan underpinned by cash flows from future profits will not change the fact that the company is insolvent today. Note that we are not saying that future profits should not be used to solve financial distress. They can and they often are. Our point is that doing so carries with it an additional layer of risk that the director should be aware of. To understand this additional risk, we begin with looking at what it means to be solvent.

A person is solvent if and only if the person is able to pay all of the person’s debts as and when they become due and payable. And a person who is not solvent is insolvent.  The key word here is ‘able’. ‘Able’ refers to ‘ability’ and ‘ability’ considers the financial means available to the person (or company) at the time solvency is assessed. ‘Financial means’ includes cash, debtors that can be collected, stock that can be quickly sold, non-core assets that can be quickly sold, assets that can be used as security for loans, the ability to refinance loans secured by the company’s assets, unsecured loans with extended repayment terms, and equity investments from shareholders (if there is a high likelihood of the investments occurring). Employing any of these measures means making use of the company’s balance sheet as it currently exists. What is not on any balance sheet at any time is future profits. Future profits are not an asset. The sea of negative arises when a director intends to use cash flows from future profits to save the company, not appreciating the layer of personal risk accompanying that strategy.

Let’s go back to our liquidity crisis. Whether or not the company is insolvent depends on the director’s plan to resolve that crisis. If the plan involves using surplus capacity of the company’s balance sheet (through the measures listed above), then it can be shown that the ‘ability’ to pay all of the company’s debts likely exists. We can therefore conclude the company is solvent.

The same cannot be said about a plan that utilises future profits. This is because future profits are not recognised as a financial means that the company can currently draw from in order to deal with its debts. You have not demonstrated the ‘able’ part of the solvency definition; therefore the solvency criteria has not been met.

Future profits are not the answer if you are designing a plan that shows the company is solvent whilst the plan is being implemented. If the plan fails and the company is placed into liquidation, it is likely that the liquidator will find that the company was insolvent when the plan commenced. And you care about this because it means that the company was insolvent for a longer period, which in turn increases the director’s exposure for insolvent trading.

The commercial reality is that many companies rely on future profits to solve financial problems that exist today. This article is not recommending against their use but instead seeks to shed light on a consequence directors may not be aware of. Being forewarned is where the ‘positive in a sea of negative’ comes in. Having been forewarned, the director can then consider steps to limit their personal exposure. These can be done informally or formally. Informally, by employing safe harbour and / or seeking further ways of using the balance sheet’s current capacity. Formally, by way of a deed of company arrangement or small business restructuring. To explore these options in the context of your circumstances, contact us. Consultations are free.