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Advising clients on when it’s time to file bankruptcy

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Bankruptcy is a very delicate topic and is usually the last thing on a business owners’ mind when they start their company. Unfortunately, thousands of business owners are forced to file for bankruptcy annually. That’s truer than ever, with COVID-19 affecting businesses around the world. The whole process can be complicated and expensive, but providing the right advice to clients can significantly lessen the burden. At Horsford Accounting & Advisory, we advise business owners on how best to approach bankruptcy and when to seek that solution.

Red flags signal a problem

Before providing any kind of bankruptcy advisory services, you have to first spot the red flags that a client may need to file for bankruptcy:

Skipping payments. Missed payments are the tell-tale sign that a business cannot meet its obligations. When a client intentionally skips payments from key suppliers, it highlights how dire their situation is. Failing to pay a supplier can cause the supplier to stop providing goods and services necessary for generating revenue, further exacerbating the business’ decline. Conversely, missing small payments can signal a cash crunch as the business owner struggles to keep some cash in-house.

Defaulting on loans. Having a loan go into default can trigger several negative consequences. First, depending on the loan agreement, a creditor can seek relief from the business’ pledged collateral. Next, credit will be impacted, hurting chances for future loans. Having assets as collateral and maintaining respectable credit are crucial when going through a bankruptcy proceeding. If a client is squandering either one, it may be time to file before it’s too late.

Being sued. If a client has lost a lawsuit and is at risk of having their assets seized, bankruptcy may be their best option. Again, maintaining assets is important because bankruptcy courts divvy up assets during a restructuring or sale.

Bleak financial projections. If it will take more than five years for a client to pay off unsecured debt, the business will probably head for bankruptcy within that time. It is likely that the business will continue to amass debt, digging itself into a deeper hole. Filing bankruptcy sooner than later may be the best bet.

Failing business in a failing industry. Businesses that are struggling to stay afloat in dying industries such as digital cameras, video stores, and vacuum repair shops, for example, are unlikely to turn their businesses around. Barring some miracle, certain industries are not coming back; meanwhile, their associated debt will remain. If it’s unreasonable to think the business will generate enough revenue to pay off its debt, it may be time to file for bankruptcy.

Discussing bankruptcy

Now that you’ve identified some red flags, here are two ways you can approach the topic of bankruptcy with your client.

  1. Speed is everything. Businesses are usually insolvent long before they actually file bankruptcy, so it’s best to advise your client to file for bankruptcy sooner than later. Doing so can stop the company from accruing more debt and will cost them less in the long run. The longer the business languishes, the more debt it will rack up. Agree on a decision to file and move forward.
  2. New bankruptcy rules are your ally. New bankruptcy rules became law in August 2019 and took effect on Feb. 19, 2020. The new rules state that companies must file debt repayment plans more quickly, preventing bankruptcy attorneys from stretching out the process to increase their fees. Gone are the Justice Department fees and formal disclosure statements that were previously required to be filed, saving business owners thousands of dollars in legal fees. In addition, business owners can retain ownership if they promise to offset their debt with future profits via monthly payments.

These new rules came at a time when business owners needed them most – as COVID-19 forced the closure of many businesses. Now, business owners can file bankruptcy faster and cheaper.

Case example

One of our clients recently considered bankruptcy because their revenue declined 79 percent due to COVID-19 and their debt ballooned up to the high six figures. The client owns a brick and mortar-based shop, but could no longer make rent payments with the reduction in revenue. To make matters worse, the owners financed the purchase of equipment right before COVID-19 hit and could no longer afford to make consistent payments.

Here’s what we did:

  • Our advisors reviewed all of their obligations and forecasted their revenue for the next three and five years.
  • We discussed the potential effects of filing for bankruptcy and the estimated cost.
  • We connected the client to a good bankruptcy lawyer and informed them of the latest rules governing bankruptcy.

Put your advisor hat on

Although the final decision was not our firm’s, we provided the client with everything they needed to make a well-informed decision. That’s your role as your client’s advisor, especially because you should be intimately familiar with a company’s financials, operating history, and long-term plan.

Giving your clients bad news is never easy, but remember you are in a unique position to offer your experience and advice.

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