Financial difficulties: how to recognise and avoid

This section explains how to avoid the causes of crises and how to recognise the signs that things are going wrong.

The health of an organisation is similar to the health of a person. Ideally, you should live a healthy lifestyle to avoid any problems. However, you should also know the symptoms of ill-health and have a treatment plan to deal with it.

How to avoid the major pitfalls

Inertia is an important factor in insolvency cases. Insolvency usually creeps up unnoticed on organisations because no-one is alert enough to stop the slide at the beginning, when it may be relatively simple; they wait till the signs are painfully obvious when it may be too late.

Some causes of financial problems which are widely recognised in the commercial sector also apply to the voluntary sector:

Management problems

One-person rule: a chief executive should not dominate their colleagues, but lead them instead. A dominating leader can result in success (Henry Ford), but also means that if the leader makes mistakes, they are likely to remain uncorrected.
Non-participatory board: this is often allied to one-person rule. Trustees or board members should not take an interest only if topic interests them.
Lack of balance in the top team: in commercial concerns, this is manifests itself in an over-abundance of engineers on the board. An equivalent in the voluntary sector might be a health-care organisation with too many health-care professionals. This weakens its fundraising or strategic expertise. A weak finance function is a particularly lethal variety of this.
Lack of management depth or experience.

Accountancy problems

Budgetary control: well-managed organisations draw up an annual budget, possibly even a five year budget. This shows revenues, interest payments, wages and so on in monthly detail. As the year goes by, the accounts department publishes actual figures which managers can compare with budget. In this way, variances can be identified and corrective action taken continuously.

In poorly managed organisations, this system is not used at all, is defective or entirely absent. The managers may not have the slightest idea whether the organisation is doing well or badly. Budgetary control is of particular importance where there are a number of branches that have wide autonomy.

Cash flow forecasts: in poorly-managed organisations, cash flow forecasts tend to be absent or they may exist but are not updated. A cash crisis can arrive unexpectedly.
Overtrading: happens when an organisation injects cash into debtors, work in progress and other aspects of operation at approximately the rate at which it is expanding.

So if an organisation has funds or £100,000 and is expanding at 20%, then it would normally expect to have to find £20,000 in cash to finance debtors, advance payments, capital expenditure and so on. If the previous year's surplus is less than this, it will have a cash shortfall, and may have to borrow.

Organisations that implement effective working capital management tend to avoid overtrading. However, failure from overtrading can strike healthy organisations as well as poorly managed ones. For example, the managers might just underestimate the amount of time it takes to arrange a loan.

Care must also be taken when the organisation takes on contracts at the expense of "profit" margins - in other words, it accepts contracts which do not adequately contribute to core costs.

The Big Project: a golden rule states - an organisation should never undertake a project the cost of which they could not write off and remain in operation. Some leading insolvency practitioners have said they feel this is one of the most common mistakes.

Tip: Before accepting a big contract, particularly one which is substantially bigger than anything you have previously undertaken, the managers should ask themselves "if this all goes wrong and we can't collect the money, or we incur penalty charges because we can't deliver as contracted, will it break us?" If the answer is yes, then perhaps the contract should be refused, or at the very least some safeguards written into the contract.

Signs that things are going wrong

Not all warning signs are financial, but there will certainly be some:

Increasing overdraft levels: if an organisation keeps coming up against its overdraft limit more frequently, then you need to check your credit control and your cash budgets against actual. Once the organisation is having to manage its cash on a daily basis rather than a monthly basis, then it is certainly in distress.
Losing clients/customers, or not getting repeat contracts - perhaps your marketing or fundraising operation is no longer as efficient, or you are not performing your contractual duties as well as you used to. If so, this needs investigating and correcting.
Losing key staff: this can itself can cause a loss of confidence in the voluntary organisations from organisational stakeholders such as funders and trustees.
Receiving red reminder letters: if the reminders come from the Inland Revenue and relate to PAYE, then these are almost certainly major problems.
Increasing bad debts: this is particularly problematic because of how hard you have to work to compensate. If the surplus on a contract or service (or its contribution to core costs) is 10% and you have a £5,000 bad debt, you have to earn £50,000 more revenue to compensate. You must have procedures to minimise bad debt.
Getting phone calls from the bank: banks have sophisticated early-warning systems - they may well pick up problems in your cash flow before you do. (But do ensure you have your own key indicators).

Tip: Every organisation has certain key areas which give a knowledgeable manager a feel for whether things are going well or badly. If you were ringing your organisation from a business trip, and your mobile phone's battery was running out, what five questions would you ask to re-assure yourself? If you don't know, perhaps you should give the matter some thought before there is a crisis.