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Peter Cox shares his thoughts on the current economic climate.

The current mood out there in small business land is not something I have seen or felt since 1990. Many report falling sales, falling margins, growing non-productive assets and slower payment of accounts. The tightening of credit by banks is the first sign of change in the small business economy. I believe this will lead to an increase in liquidations in this industry.

Liquidation is commonly known as ‘winding up’, which is the process by which business assets are ‘liquidated’ and the company closed and probably deregistered.

For a company to go into liquidation there is one term that needs to be understood, that is, insolvent. A company is solvent if it can pay its debts when they fall due and is insolvent if it cannot.

A quick test of solvency is to calculate your working capital position.

Working Capital = Current Assets – Current Liabilities

This gives a dollar value to the difference between what needs to
be paid by the business (current liabilities), against what is in the bank and what is owed to the business by the debtors (current assets). Instead of using the dollar value, some financiers refer to the relationship between assets and liabilities as the current ratio.

Current Ratio = Current Assets / Current Liabilities.

If, for example, a business has current assets of

Cash $20,000, Debtors $25,000, Inventory $10,000, the total current assets is $55,000.

If the business has current liabilities of Creditors $5000 Bank Overdraft $20,000 Provisions (leave, sick pay etc.) $5000 the total current liabilities is $30,000.

Then the current ratio is $55,000 divided by $30,000 or a ratio of 1.83 to 1. Most banks would prefer to see a ratio of 2 to 1 for a healthy business.

The working capital in dollars is $55,000 – $30,000 = $25,000

If the cost in running the business (includes rent, interest, insurance, and wages) is $12,000 a month, then the operation has just over two months coverage of running costs ($25,000 / $12,000). If the company’s overheads are $35,000 a month then there is a problem.

Remember, a company is solvent if it can pay its debts and bills when they fall due and is insolvent when it can’t.

The financial state of the company is important because it determines what kind of liquidation the company will enter, as well as the type of investigations that a liquidator will undertake.

If the company is solvent and the ‘winding up’ is voluntary – typically when the owners or shareholders simply decide to close the business – the company debts will normally be paid. However, when a company is insolvent this does not always happen and it is more likely that the process of winding up will involve court liquidation and creditors voluntary wind-ups of insolvent companies.

The role of the liquidator in an insolvent liquidation is mainly to collect, and deal with, the company’s assets. If possible, the assets are converted to cash for distribution to the creditors. Once the creditors have been paid, only then will shareholders receive any payout, however this rarely occurs.

The liquidator also conducts investigations into why the company failed and importantly review the conduct and decision making of the directors, as well as the conduct of other parties such as creditors.

The liquidator also has the power to ‘claw back’ certain transactions involving a creditor. These transactions are known as ‘unfair preferences’. An unfair preference is a payment made to a creditor in the six months before the liquidation started. To be classed as an unfair preference the payment must have been received whilst the company was insolvent or it causes the company to become insolvent and the creditor must have received more than it would have received in the liquidation. Liquidators can claw back unfair preferences via an application to the court.

Two important take-outs for managing a business in uncertain times:

  1. Keep an eye on your own business to ensure you have sufficient working capital. Directors have a fiduciary duty to shareholders and can potentially be liable if, as a Director, the business that has gone into liquidation was incurring debt whilst insolvent.
  2. Be cautious if you are dealing with a company you are concerned may have financial problems. Even though you may have been paid, it does not mean that you are out of the woods, if the payment was made to your business when the customer was insolvent.

Peter Cox, Director, Peter M Cox & Associates