The Corporations Act 2001 sets out the laws for corporations, financial products and services in Australia. As in Section 95A the Corporations Act 2001 defines insolvency as follows:
- A person is solvent, if and only if, the person is unable to pay all the person’s debts, as and when they become due and payable.
- A person who is not solvent is insolvent.
Despite this simple definition, declaring a business insolvent simply based on a cash flow problem can be troublesome since this dilemma might only arise short-term and not represent an inevitable insolvency. There are certain key indicators to measure a business financial strength, operating performance and liquidity to reduce the need for future debt collection.
The current Ratio is often used by investors to measure business liquidity by comparing its short-term assets (cash, inventory, receivables) to short-term liabilities (debt and payables). Since short-term liabilities are due within the next year, it means that the business has a limited amount of time to pay for those. The formula for calculating a business Current Ratio is dividing its current assets by current liabilities. In general, a ratio of 2 to 1 represents a low-risk potential for the creditor, whereas a ratio below 1 would indicate that the business might not be able to pay its obligations when due short-term.
The Receivable Turnover ratio is another measurement that helps to evaluate how efficient a business uses its assets by turning its accounts receivables into cash during an accounting period. To calculate Receivable Turnover, divide the annual net credit sales by the average accounts receivable. For example, if a business had $80,000 of average receivables during the year and collected $160,000 of receivables during the same year, the business would have turned its accounts receivable twice because it collected twice the amount of average receivables. If Receivable Turnover is tracked on a trend line and slowing down, this might indicate an increase in funding for the collection staff and worth looking into the reason why turnover is declining.
A company’s Gross Margin reflects its total sales revenue less its cost of goods sold. It is frequently expressed as a percentage and calculated with the simple formula net sales minus cost of goods sold, divided by net sales. The percentage allows a comparison between businesses with different sales levels, the higher the percentage the more efficient the business.
If these formulas are early applied and the key indicators understood by the business directors, instant action can be taken to avoid terminal insolvency.
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