What Causes Insolvency? Avoid These Common Business Management Mistakes

What causes insolvency? It is a more complex question than meets the eye. In South Africa, a business is insolvent when its liabilities exceed its assets and the business is unable to service its debts. According to law, a business must seize trading if it is insolvent, as to protect creditors. However, understanding what causes insolvency of a perfectly good business can help you avoid the situation altogether, ensuring ongoing business operations.

With more than 50% of businesses failing even before reaching the one-year milestone, you can understand why it is important to understand what causes insolvency and how to avoid such. There are many reasons for business failure, of which some are briefly discussed below.


Lack of Knowledge Regarding Business and Commercial Practices

Having worked in a corporate setting for ten or more years does not prepare you for all the challenges that an entrepreneur faces. You use your pension or retrenchment money, in addition to a financial loan, and start your own business. However, not having expertise in specific business operations is what causes insolvency, since you make avoidable investment and cash flow management mistakes. Also, not understanding the very basics of commercial practices, such as your obligations regarding a property lease contract or service level agreement can cause severe financial losses. This can push your business into the red and become the cause of its insolvency.


Not Having Sufficient Resources to Grow A Business

Many people start or buy businesses without having additional capital to run the operations. If you, for instance, buy a car wash, but do not have enough capital to purchase essential equipment, market, and add essential services, you are unable to stay competitive. Many restaurants also go under because the owners do not have sufficient money to purchase stock. Without stock, it is not possible to prepare the dishes and the downward spiral starts as the business buys stock on credit, but not being able to pay the suppliers leads to legal action against the debtor.


Failure to Pay Creditors

When it comes to what causes insolvency quicker than anything else, the answer is not managing debt. This is the case whether it is a business or individual. If the business owner does not pay debts due on time, such debts build up, and pretty soon, become unmanageable. Once the liabilities exceed the assets and the business cannot pay creditors, it is insolvent.


Not Managing Expenses

Yes, one cannot expect a business to grow without investment. However, not managing expenses is what causes insolvency. You cannot borrow and spend R100 000 on the décor of a small cupcake shop that can realise a maximum of R30 000 monthly turnover with rental of the premises standing at R10 000, and employee salaries at R8000. You must repay the loan, pay overheads, and still manage to keep figures in the green. Unless you spend in proportion of growth, keep overheads low, and avoid large capital layouts when you have limited funds, as you risk causing the insolvency of your business.


Cash-Flow Problems

When it comes to what causes insolvency, cash flow issues should be listed first. However, one can work with limited cash, as long as you put money aside to cover unexpected expenses. SARS can come knocking at your business door for provisional taxes payable. Have you set money aside? Not paying SARS is certainly a fast track towards insolvency.


Credit Based on Potential Revenue

Never apply for credit based on future income. This is a common problem with small contractors. They enter into business arrangements with large firms for once-off projects. To complete the projects, they need equipment and related products. They apply for credit to purchase the equipment and pay staff.

However, any delays in the completion of the projects or payment by the client can cause the business to fail. It cannot pay its debt because it waits for payment. It is not able to pay salaries and cannot complete the project. This can be so even if it is almost at the end of the project. The commissioning firm simply withholds payment, and the smaller service provider has to close doors. The bottom line is that credit based on potential revenue is risky.

Speak to our attorneys about what causes insolvency, and benefit from their expertise in helping your business to avoid legal pitfalls in trying to manage debt.


Disclaimer: This article is for informational purposes only and does not constitute legal advice. Call on our attorneys for legal advice, rather than relying on the information herein to make any decisions. The information is relevant to the date of publishing.

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