Early detection of a serious illness often can mean the difference between life and death. Likewise, early detection of the symptoms of insolvency can also save a business.

“Continuing losses and dwindling cash reserves are symptoms of a new and evolving but undefined area of bankruptcy known as the ‘zone of insolvency,’” says Gleason & Associates’ Tom Pratt. “If we can diagnose when a company is in the zone, we can often develop a reasonable plan of action to help it preserve and generate cash flow, and ultimately avoid insolvency.”

Early detection is important for other reasons. When a company is in the zone, management’s responsibilities must expand to safeguard creditors and other stakeholders in addition to shareholders. Failing to act responsibly in the zone of insolvency can subject a company and its officers and shareholders to further distress.

“Management must make a good faith effort to uncover problems, identify solutions and act prudently with all of the stakeholders in mind,” says Pratt.

Recently, Gleason & Associates was asked by counsel representing the creditors of a bankrupt company to evaluate whether management took appropriate action in the zone. A valuation analysis determined that the company, while not insolvent, was experiencing financial troubles. An analysis of management’s actions during the difficulties revealed that it had curtailed spending, focused on core operations in an attempt to restore profitability and even tried to sell the business.

“Although management was ultimately unsuccessful, our analysis determined that it did what it could to prevent the bankruptcy,” Pratt explains.

Gray Area
The zone of insolvency covers companies in financial distress that do not meet the two technical definitions of insolvency. Insolvency occurs when a company either cannot pay its debts as they come due or the amount of its liabilities exceeds the value of its assets. But when does financial distress turn into the zone? Does the zone of insolvency always proceed insolvency? How long does the zone last? The answers are up for debate.

“While it’s not clear how much time a company may have to turn things around, it’s important to seek help as soon as symptoms of the zone of insolvency appear,” notes Pratt. “A valuation analysis can determine if the value of a company’s assets exceeds its liabilities. A cash flow analysis and forecast can identify how close a company is to not paying its bills. A financial reorganization plan can help management focus on the company’s core business to preserve and generate cash.”

Detecting the Zone
Early detection of these symptoms can help prevent insolvency:

• Continuing financial losses are draining cash.
  
• Changing business conditions are negatively effecting cash flow projections.
  
• Accounts receivable and inventory balances are increasing.
  
• Raw material supply has deviated from the norm.
  
• Market share and customer orders decline precipitously.