Category: Budget and Forecast

Estimated reading time: 10 minutes

Introduction

In part I of this post, we defined what it means for a company to be a going-concern. We also discussed why you should evaluate your company’s ability to continue as a going-concern, and why it was important. In this post, I’ll give you a framework to approach the evaluation. I’ll also offer some lessons I’ve learned over the years. An important thing to note here is that obviously this article is general in nature. I am not offering specific advice to you or your company. You should always discuss these matters with your company’s accounting, financial and legal advisors.

I’m going to use Excel to illustrate one way to perform a going-concern evaluation. Please register and I’ll be happy to send my template to you (its free).

Step 1: the initial evaluation

Our initial evaluation will be based on our currently-available resources, and the expected results of our current operating plan. Did Step 1 indicate that the company probably will continue as a going concern? If so, then we are finished. If the results of step 1 indicate a problem, however, then we proceed to Step 2. In step 2 we will take into consideration any plans that could mitigate the possible liquidity shortage.

I. Analyze the balance sheet

Start with your current balance sheet. First, identify assets that are either cash, or can easily be turned into cash without disrupting the ongoing business. Amounts invested in savings accounts or in marketable securities are good examples. We will refer to this amount as opening cash resources.

You should not usually assume that other assets, such as accounts receivable or inventory will be converted into cash. Since we are assuming that your business will continue as a going concern, you should expect that these asset balances will be replenished over time as current amounts are used. Similarly, as you repay existing accounts payable balances, presumably they will be replaced as you make future purchases from vendors.

One exception to this assumption would be if there was an unusually large or small balance on the balance sheet date. Some examples:

• The balance sheet includes a large overdue accounts receivable balance. However, it was subsequently collected before the financial statements are issued. You should consider adding that amount to your opening cash resources.
• Inventories are unusually low on the balance sheet, but will need to increase back to more normal levels. You should consider the additional investment in inventory as a use of cash.

Here is one way to look at your opening balance sheet. Again, the intent is to document what our opening cash resources will be.

II. Evaluate the expected results of your operating plan

Remember, the point of this exercise is to see your company will continue as a going-concern for at least a year. To do this, we will consider our most likely operating results, along with our existing cash resources.

Expected operating results should be your most reasonable guess at the most likely outcome. Don’t be overly optimistic here, but don’t overdo the pessimism either. It is always a good idea to “stress-test” the outcome with a worst-case scenario, though, and think about how you might mitigate its effects. In an earlier article, I’ve added some suggestions to improve your budgeting and forecasting process.

Below is a sample summarized operating forecast. In this example, we plan to issue our 2020 annual financial statements during the first quarter of 2021. Therefore, our reporting period extends through the first quarter of 2022.

One important point: operating expenses should only include “cash” expenses. Exclude non-cash expenses like depreciation, amortization, accrued rent or share-based compensation expense.

Everything looks fine until the first quarter of 2022, when the debt is due and we don’t have the cash to pay it. The balance sheet looks solid, and the company is operating at a profit, what could go wrong? There is a time bomb lurking in the near future: a balloon payment on the debt. This is a situation where the going-concern evaluation can provide valuable information to the reader of the financial statements. It is also valuable information to you, the company’s management. You can often do something about it. In this example, we would conclude that there may be substantial doubt that the company will be able to continue as a going concern.

What are the implications?

• We could resolve the issue before the financial statements are ready to issue. Some options would be to refinance the debt, or raise additional equity capital. We would then revise the forecast to reflect the refinancing, conclude there was no substantial doubt and be finished. You would, however, consider including a “subsequent event” footnote to the 2020 financial statements disclosing the details of the new financing. Figure 3 illustrates the refinancing of the debt with a new $3 million loan during the first quarter of 2021.
• If the issue cannot be resolved before the financial statements are issued or ready to issue, we would conclude there is substantial doubt about the company’s ability to continue as a going-concern. The footnotes to the 2020 financial statements would include a footnote disclosing the issue, and we would move on to Step 2.

Step 2: Management’s plans

The next step is to think about the things the company’s management team can do to avoid running out of cash. As you assemble your list, indicate whether each action is feasible of being implemented within one year. Consider the company’s specific facts and circumstances. Also, quantify the effect of implementing each plan. As a general rule, an action can only be consider probable if management or others with the appropriate authority have approved before the financial statements are issued.

Examples of probable and feasible plans

Here are some examples of plans that could be probable and feasible as of the date the financial statements are issued.

• Sell an asset or business. A multi-store retailer could sell one or more stores, for example. Some things to consider:
  • Has senior management approved the plan to sell?
  • Is approval of the board of directors necessary, and if so have they approved?
  • Are there loan covenants or other encumbrance on the asset?
  • Does a market exist for the asset or business?
  • How would disposing of this asset or business change my forecast?
• Restructure the debt. Some things to consider:
  • Availability and terms of new debt financing.
  • Are there existing or committed arrangements to restructure or refinance debt?
  • Any restrictions on additional borrowing. Is there sufficient collateral?
• Reduce or delay expenditures. Some things to consider:
  • Evaluate the feasibility of reducing overhead or administrative expenses.
  • Can maintenance or research and development projects be postponed?
  • How will the plan change the forecast?
• Increase equity capital.
  • Will existing investors infuse additional cash into business?
  • Is it feasible to attract new equity investors?

Step 3: Disclosures

The final step in the evaluation is writing the appropriate footnote to the financial statements. The information in the footnote will depend largely on an evaluation of management’s plans.

Will the plans that I’ve identified to be both probable and feasible alleviate the events and conditions that raised substantial doubt?

Let’s change the facts slightly in our example above. Assume that the debt refinancing was not completed before the financial statements are to be issued, but there is an approved plan to do so in the third quarter of 2021.

The footnotes should include information that enables users of the financial statements to understand all of the following:

• the principal conditions or events that raised substantial doubt about the company’s ability to continue as a going concern (before consideration of management’s plans).
  • In our example above, we would discuss the long-term debt, the balloon payment due in early 2022.
• management’s evaluation of the significance of those conditions or events in relation to the company’s ability to meet its obligation
  • In our example above, we would discuss why we believe the company would not be able to make the debt payment given its available resources.
• plans that alleviated substantial doubt about the company’s ability to continue as a going concern
  • In our example above, we would discuss the approved debt restructuring plan.

A footnote disclosure might look something like this:

Under the terms of the Company’s existing debt facility, the Company would be obligated to repay all outstanding obligations of approximately $4.1 million on March 1, 2022 (the “Debt Repayment”). After evaluating the Company’s existing cash and cash equivalents along with its expected results of operations, management concluded it was unlikely that the Company would be able to make the Debt Repayment when due. The Company and its lender have agreed a plan to refinance the debt facility with a new $3 million credit facility. Under the terms of the new credit facility, repayment will be required five years following the finalization of the new credit facility. Management believes the proceeds of the new credit facility, along with available cash and cash equivalents will enable the Company to satisfy the Debt Repayment.

Will the plans that I’ve identified to be both probable and feasible mitigate, but not completely alleviate the substantial doubt?

The footnote should contain the statement indicating that there is substantial doubt about the company’s ability to continue as a going concern within one year after the date that the financial statements are issued.

Additionally, the footnote should include information that enables users of the financial statements to understand all of the following:

• the principal conditions or events that raised substantial doubt about the company’s ability to continue as a going concern (before consideration of management’s plans).
• management’s evaluation of the significance of those conditions or events in relation to the company’s ability to meet its obligation
• plans that are intended to mitigate the events and conditions that raised substantial doubt about the company’s ability to continue as a going concern

A footnote disclosure might look something like this:

Under the terms of the Company’s existing debt facility, the Company would be obligated to repay all outstanding obligations of approximately $4.1 million on March 1, 2022 (the “Debt Repayment”). After evaluating the Company’s existing cash and cash equivalents along with its expected results of operations, management concluded that there was substantial doubt that the Company would be able to continue as a going concern through at least March 31, 2022. Management’s plans may include continuing to seek additional debt or equity capital, the reduction of administrative operating expenses, the delay or cancellation of planned research and development projects and the sale of assets. There can be no assurance that any of these plans will be successful.

Conclusion

Hopefully, you can see why the evaluation of going-concern is so important. It is important for the users of your company’s financial statements. But it is even more important for your company’s management team. As with most things in life, anticipating problems before they happen and taking action early can avoid embarrassing and unpleasant results.

Try to think about the worst things that could happen and what effects they could have on your company. Have a contingency plan in place if any of those events become more likely.

To summarize, the steps are:

1. Is it likely your company will be liquidated in the near future? Hopefully not!
2. Does your operating plan, along with your existing resources generate enough cash to meet your company’s obligations for the next 12-15 months?
3. If not, are there plans that you can probably and feasibly implement that will alleviate the shortage?
4. If not, are there at least plans that you can probably and feasibly implement that will mitigate the shortage?

Let’s Connect!

If I can be of assistance, please let me know! I’m happy to answer questions you might have about this article, and how you might approach your own company’s going concern evaluation.

Estimated reading time: 7 minutes

Are you required to issue financial statements prepared under generally accepted accounting principles, or GAAP? Do you report on a calendar year basis? If so, it’s time to start thinking about financial reporting for year 2020. Over the next few weeks I’ll be talking about things to consider as you prepare your 2020 annual financial statements. High on the list is an evaluation of your company’s ability to continue as a going concern. Thinking about these things now will save time for you and your accountant. An important thing to note here is that obviously this article is general in nature. I am not offering specific advice to you or your company. You should always discuss these matters with your company’s accounting, financial and legal advisors.

GAAP

The authoritative source of Generally accepted accounting principles, or GAAP is the Financial Accounting Standards Board, or FASB Accounting Standards Codification. For more information visit their website. GAAP applies to all nongovernmental entities reporting in the U.S. In addition to GAAP requirements, publicly-traded companies may have additional reporting requirements under the rules of the U.S. Securities and Exchange Commission, or SEC.

Not all companies prepare GAAP financial statements. They are frequently required by lenders or investors and if you intend to “go public” someday, GAAP financial statements will be a requirement. Whether you prepare GAAP financial statements or not, it’s a good idea to evaluate your company’s financial health and prospects at least annually, particularly this year.

One final point about GAAP. I’m writing this article about annual reporting. Many privately owned companies only prepare full GAAP financials annually. The requirements below apply equally to interim financial statements, so if you prepare full GAAP financials on a quarterly basis, you should be looking at going-concern every quarter.

What is a Going Concern?

Simply, a company is a going concern if it can meet its financial obligations as they become due. Under the GAAP rules, a company is either a going concern or is facing imminent liquidation. Basically, imminent liquidation means either the company’s management has made the decision to liquidate the company, or an outside party can compel liquidation (an involuntary bankruptcy petition, for example). Accounting for and reporting on companies facing imminent liquidation is beyond the scope of this article.

Going Concern Evaluation

As you prepare financial statements under GAAP, you should evaluate whether there are conditions and events, considered in the aggregate, that raise “substantial doubt about an entity’s ability to continue as a going concern within one year after the date that the financial statements are issued…” In other words, given the conditions of the company, its competitive environment, overall market conditions and other factors is it likely that the company will continue to be able to meet its financial obligations for at least a year from the financial statement issue date? The outcome of this evaluation can trigger additional disclosure requirements in the footnotes to the financial statements.

Under the best of circumstances, this is a complex evaluation. Year 2020 has not generally been the best of circumstances! Every business faces risks and uncertainties and this year we add the COVID pandemic into the mix. You need to evaluate your company’s ability to remain viable through early 2022 as you prepare your 2020 financial statements.

Conditions and Events to Consider

Here are a few examples of the types of uncertainties to consider. This is by no means a complete list, just a few ideas to think about.

Some examples

• Have COVID-related lockdowns affected your business? Arguably, the lockdowns may be temporary, but what if they aren’t?
• Perhaps due to the lockdowns, has your business’s marketplace changed? If you are a chain of retail stores, for example, have your customers buying habits changed to on-line versus in-person shopping?
• If you are in the hospitality industry, consider whether business travel and entertainment will return, or has the availability of virtual meetings at least partially eliminated the need for travel?
• Has your business lost critical talent? How likely is it that replacements will be found and retained? What will the impact be on future business if critical vacancies remain unfilled for prolonged periods?
• Is your business reliant on a single or few customers or suppliers who may be having financial difficulties?
• Is your business reporting negative financial trends, defaults on loans, an upcoming debt repayment, legal proceedings, unfavorable legislation or regulatory actions.

Evaluation process

Your evaluation should include all expected revenues and costs and the effects of other known events or circumstances. Does your analysis concludes that there is substantial doubt about your company’s ability to continue as a going concern? If so, think about and document the steps you might take to mitigate that doubt. We will call those steps “management’s plans.” To the extent management’s plans can be fully implemented before the financial statements are issued, it is appropriate to take them into consideration even if they occur after the balance sheet date. For example, if a company receives $10 million in additional capital in late January, and plans to issue its financial statements in February, the additional capital should be considered in the going concern evaluation.

Required Disclosures

The conclusion of your evaluation will result in one of three outcomes:

1. There is no substantial doubt about your company’s ability to continue as a going concern.
2. Substantial doubt is raised, but it is alleviated by management’s plans.
3. Substantial doubt is raised and is not alleviated by management’s plans

There is no substantial doubt about your company’s ability to continue as a going concern:

If your evaluation concludes there is no substantial doubt about your company’s ability to continue as a going concern, then you are finished and no disclosure is required. Be sure to save all of your documentation related to the evaluation. The exception to this rule is if your company has previously disclosed substantial doubt which is now resolved, you should discuss in a footnote how the conditions and events that contributed to that substantial doubt were resolved.

Substantial doubt is raised, but it is alleviated by management’s plans.

Discuss the following in a footnote to the financial statements:

• The principal conditions or events that raised substantial doubt about the company’s ability to continue as a going concern (before consideration of management’s plans)
• Management’s evaluation of the significance of those conditions or events in relation to the company’s ability to meet its obligation
• Management’s plans that alleviated the substantial doubt.
  • You should only include plans that will probably be implemented. As a general rule, for this purpose a plan can be considered probable only if it has been approved by management or others with the appropriate authority before the financial statements are issued.
  • Some examples of plans could include plans to dispose of an asset or a business, plans to borrow money or restructure debt, plans to delay or reduce expenditures and plans to raise additional equity capital.

Substantial doubt is raised and is not alleviated by management’s plans.

Discuss in a footnote to the financial statements:

• The principal conditions or events that raised substantial doubt about the company’s ability to continue as a going concern (before consideration of management’s plans)
• Management’s evaluation of the significance of those conditions or events in relation to the company’s ability to meet its obligation
• Management’s plans that are intended to mitigate the events or conditions that raise substantial doubt.

Conclusion

One point I’d like to stress: do this evaluation at least once a year, especially this year. Even if it is not required. Do it as soon as you can. It can be an eye-opening experience. If you see trouble down the road there are probably steps you can take now to mitigate or even prevent a liquidity crisis later.

So far, we’ve talked about what needs to be done and why it is important. In part II of this article, I’m going to share a framework that I’ve used over the years to do this evaluation. I’ll also give some practical advice how to approach and perform your evaluation.

You might find my recent article “9 ways to improve your company’s budgeting process” helpful in preparing your going-concern evaluation.

If I can be helpful in your evaluation process, please let me know. I’m always happy to answer questions.