When an entrepreneur lacks financial awareness, they will often firefight financial distress with short-term fixes which can cause more harm over the long term than benefits. This may involve taking on a high-interest emergency loan to plug a cash flow gap or plugging the startup with personal funds, for which the consequences can be serious, writes Sharon McDougall, a company debt specialist at Scotland Debt Solutions.

Plugging personal funds to stifle financial distress

It’s common practice for entrepreneurs to dip into their personal funds to prevent their startup from running out of cash due to being unsure about what professional guidance is available for startups, such as an insolvency practitioner for insolvency and restructuring advice, or a corporate finance specialist for a finance boost.

This can put the startup at risk of spiralling into debt, deeming the entrepreneur a substantial creditor. Once this cash pool drains, the financial cushion afforded by the entrepreneur’s personal funds will gradually deflate and threaten the viability of the startup.

A lack of knowledge about the help available for startups can disconnect them from essential support systems.  As such, it’s essential for entrepreneurs to verse themselves on navigating financial challenges, particularly given current economic headwinds.

Investing in financial awareness to foster success

The key to success for any business, young and old, is for the leader to build on their financial awareness to track financial health on a rolling basis. This can help the entrepreneur steering the ship recognise when the business approaches calm and turbulent waters, which is key information for budgeting and investment decisions.

Investing in financial awareness can encourage awareness of all the factors that feed into good health, such as healthy cash flow, sufficient working capital, tight credit control functions and stringent payment terms. Armed with this information, the business owner can keep a close watch on trends and raise the alarm if the business enters rocky territory that could compromise financial health.

What warrants sounding the alarm bells?

Sounding the alarm bells at the first sign of financial distress can prevent the health of the startup from deteriorating and provide it with a fighting chance to achieve financial targets. Acting early can maximise the range of support options available, prevent disruption to operations and staff, and protect the reputation of the startup, which is what investor appetite often hinges on.

A top-level understanding of the warning signs of insolvency can provide a life ring to startups veering into financial difficulty. Here are some warning signs to note:

• Cash flow shortage – a shortage of cash flow can trigger a chain reaction across the startup, from late payments, and creditor pressure to reduced growth
• Disproportionate balance sheet – if business liabilities outweigh assets, the startup owes more than it is due which marks a tipping point
• Heavy accounts receivable – a common and underestimated warning sign of insolvency is continuous accounts receivable either due to the inability of the startup to collect debts or a high late payment rate
• Creditor pressure – increased creditor pressure can indicate unhealthy cash flow and potential insolvency if payments are persistently late
• Unmanageable debts – if mounting liabilities overwhelm the startup and cause strain, the future viability of the startup could be at risk
• Reduced startup value – if the value of a startup drops due to a consistently heavy financial burden, the knock-on impact may involve investors reducing or pulling funding and difficulty raising future funds. This is why early intervention is vital

Operating a business in financial distress can cut short the life of a startup and have serious consequences for the entrepreneur. While the threat of insolvency may be accelerated by external factors, such as harsh economic conditions, legislative reforms, regulatory changes or global trading pressure, actively managing insolvency risk can protect the prospects of both the startup and the entrepreneur.

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