Careless selection of contractors and improper management of trade liabilities and receivables causes of entrepreneurs’ bankruptcy
Bankruptcy law indicates as a basis for declaring a debtor bankrupt a state of insolvency, which has been defined as the loss of the ability to pay its due financial obligations. Therefore, it is important to maintain financial liquidity, which may be lost as a result of erroneous decisions regarding cooperation with counterparties.
The analysis of financial liquidity is the most important element of analysing the situation of an entrepreneur. Entities that are viable but lack liquidity can have serious problems doing business. One of the basic accounting principles is the accrual principle, according to which all costs incurred and revenues earned are assigned to the reporting period in which they occurred, regardless of the payment made or cash inflow. As a result of the application of this principle, an entrepreneur disclosing a net profit in the balance sheet and in the profit and loss account may have difficulties with settling its current liabilities. The cash flow statement shall be a valuable supplement to the information presented in the balance sheet and the economic outturn account and shall use the cash accounting principle.
Deferring the date of settling trade liabilities by the counterparty, i.e. granting a trade credit, is a common practice in business transactions. Setting a credit policy should be an important element of the entrepreneur’s activity, which must take into account long-term plans and not focus exclusively on current financial inflows. Entrepreneurs with high profits can pursue a diversified policy. However, when the profitability is low, the entrepreneur should not allow a situation in which the level of overdue receivables is too high.
Three credit policies can be distinguished: aggressive, conservative and flexible. Implementing an aggressive strategy, the entrepreneur sets short payment terms for his contractors and requires them to strictly observe them. It also provides legal security for loans and favours customers with low credit risk. The consequence of this strategy is lower sales. The trader adopting a conservative strategy applies a lenient collection policy. As a result, it may achieve higher sales, but the risk of an increase in overdue receivables and the risk of insolvency also increases. A flexible strategy, on the other hand, is an intermediate option between the strategies described.
When establishing a credit policy and selecting contractors, an entrepreneur should take into account the financial condition and credit policy of the counterparty. In particular, the economic and capital situation of the counterparty, its profitability, financial standing and credit risk should be assessed. The granting of trade credits to counterparties should also be proportionate to the extent to which counterparties are able to obtain them.
Entrepreneurs often regard late payment as a way of crediting their businesses. Meanwhile, the lack of timely payment of trade liabilities results in payment bottlenecks, which are one of the main causes of business failure. There is a domino effect. An entrepreneur, by failing to pay his liabilities, may cause the loss of financial liquidity of his counterparty and, consequently, the deterioration of the financial situation of subsequent entities.
To sum up, having financial liquidity is essential for the proper conduct of business. Making a profit is not a guarantee of protection against bankruptcy. The risk of losing liquidity can be reduced by managing trade liabilities and receivables properly, which should be an important element of the entrepreneur’s business. The adoption of the wrong credit policy strategy can lead to the collapse of the entrepreneur. One should also remember to check the financial standing of potential contractors and to be prudent in undertaking cooperation with entities that are characterised by high credit risk.