How to Tell if a Company Will Make it to Next Year

The going concern concept is one of the basics of financial accounting. And with US corporations begging for money like my kid on skate night, it’s become a hot issue.

Without the assumption that a business is going to continue into the future to pay its debts, the balance sheet becomes meaningless. To be considered a going concern the business entity is assumed to continue to operate indefinitely. It functions without the intention or threat of liquidation for the foreseeable future. (Historically at least one year beyond the balance sheet date.)

Stakeholders like creditors, employees, and shareholders want information about the factors that threaten going concern:

• substantial losses
• availability of credit
• potential litigation
• possible loss of a major customer
• potential patent sale
• current ratio near the loan agreement limit

Predicting the Future Accurately

Despite the relatively straightforward definition, the application is difficult, the determination complex, and an auditor’s stamp of approval or disapproval may not count for much in the end. While auditor’s take a stand, it is ultimately management who know if the company will survive (or not).

Management’s assessment of the going concern assumption requires judgments about the future, which are inherently uncertain. Making matters worse:

• The further out into the future you look, the higher the degree of uncertainty.
• Judgments about the future are based only on information available today.
• The bigger the organization and the more it is subject to external factors, the more difficult the fortune telling becomes.

What Causes a Business to Fail?

There are many things that can impair a firm’s ability to continue as a going concern. Here are some areas auditors typically consider:

• Fixed term borrowings approaching maturity with no prospects of renewal or repayment
• Excessive reliance on short term borrowing to finance long-term assets
• Negative cash flows
• Adverse key financial ratios
• Substantial operating losses
• Significant deterioration in the value of assets used to generate cash flows
• Arrears or discontinuance of dividends
• Persistent rescheduling of creditors’ payments
• Shift from buying on account to buying for cash would ordinarily be cause for concern
• Rescheduling formal loans
• Inability to secure financing for essential new product development or other essential investments
• Loss of key management without replacement
• Loss of a major market, franchise, license, or principal supplier
• Labor difficulties or shortages of important supplies
• Non compliance with capital or other statutory requirements
• Pending legal or regulatory proceedings against the entity that may, if successful, result in claims that could not be satisfied
• Changes in legislation or government policy expected to adversely affect the entity

While any of these issues considered serious in isolation may not be cause for concern, it is reason to question management’s plan for resolving the situation in the coming year.

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