Australia’s economic landscape has seen a noticeable increase in insolvency events over the last 12 months. Small and medium-sized enterprises, in particular, have been hit hard, struggling to cope with reduced cash flow and mounting operational costs. Recognising the early signs of financial strife is crucial, so business owners can address issues before they become insurmountable.
Economic factors
Inflationary pressures have led to higher prices for essential goods and services, placing a strain on household budgets and increasing operational expenses for businesses. Small and medium-sized enterprises (SMEs), which often operate with more narrow profit margins, are particularly vulnerable to these cost increases. They face the difficult decision of whether to absorb the higher costs or pass them on to customers.
Employees, facing increased living expenses, may demand higher wages, and while businesses may seek to accommodate these demands to retain talent and ensure employee satisfaction, higher wages contribute to overall operational costs.
Inflation has eroded consumer purchasing power. As prices rise, the real value of consumers’ incomes effectively falls, leading to reduced spending power. For businesses, this translates into lower sales volumes as consumers become more cautious with their expenditures.
Inflationary pressures also affect borrowing costs. The Reserve Bank of Australia has increased interest rates to control inflationary trends. Higher interest rates lead to increased borrowing costs for businesses, affecting their ability to finance operations, invest in growth, and manage existing debt. The increased cost of borrowing can be a significant barrier to growth and financial stability.
Enforcement activity by the ATO
In recent months, the ATO has intensified its enforcement activities, focusing on increasing compliance and addressing tax evasion. A central aspect of this crackdown is the issuance of Director Penalty Notices (DPNs), a powerful tool designed to hold directors personally accountable for their company’s tax liabilities.
A DPN is a legal notice issued to directors of companies that have failed to meet their tax obligations, and under the Director Penalty Regime, directors can be held personally liable for these unpaid taxes if the company fails to remit them.
There are two main types of DPNs:
- Non-Lodgement (lock down) DPNs: Issued when a company fails to lodge its tax returns on time. Directors are liable for unpaid amounts if the company does not rectify its lodgement obligations within a specified period.
- Unpaid Amount DPNs: Issued when a company has lodged its returns but has not paid the tax owed. Directors are personally liable for the unpaid amounts if the company fails to settle them or seek a form of debt relief through external administration.
Insolvent trading
For directors of Australian companies, trading while insolvent can carry severe legal and financial risks. The principle of “trading while insolvent” refers to continuing to operate a business when it is unable to pay its debts as they become due. Australian directors must be acutely aware of the risks involved in such practices, as outlined under the Corporations Act 2001 and enforced by regulatory bodies like the Australian Securities and Investments Commission (ASIC).
If a director knowingly allows their company to continue trading despite insolvency, they can be held personally liable for the company’s debts. This legal obligation is strict, and directors can face civil penalties, including substantial fines, disqualification from managing corporations, and, in severe cases, imprisonment.
Warning signs of insolvency
Recognising the early signs of financial strife is crucial, so business owners can address issues before they become insurmountable. Here are some key indicators that a small business may be facing financial trouble:
- Declining cash flow;
- Increased debt levels;
- Missed or late payments;
- Declining sales and revenue;
- Employee turnover and morale issues; and
- Difficulty in obtaining financing.
Lenders and investors are typically cautious about extending credit to businesses that show signs of instability, such as declining revenues or high debt levels.
Published 8 October, 2024