When you admitted to the partnership as an equity partner, whether fixed share or full equity, you will be asked to make a large capital contribution to your firm. This means that you need to do your due diligence on your own firm, before formally accepting the offer of partnership. One of the areas of due diligence you need to do is to check exactly how solvent your firm is both now and in the future. In this article, taken from an extract from Poised for partnership, we look at how to check the solvency of your firm.
Could your capital contribution be propping up an ailing firm?
There is a very real danger that your capital contribution could be used to prop up an ailing firm. As well as risking your own money in this situation, and leaving you with hefty personal debts, you could also face a large reputational risk. Being a partner in a firm that goes bankrupt is a large black mark on your own reputation and character.
What do you need to see to check how solvent the firm is?
To get an idea of how solvent your firm is, ideally you need to have sight of the last three years of annual accounts and the most up-to-date management accounts. After all, annual accounts can be massively out of date and, therefore, hide any growing financial hole in the firm.
What should you check on the balance sheet?
The firm’s balance sheet gives you a snapshot of your firm’s assets and liabilities at a fixed point in time. The first test for the firm’s solvency is to check that the current assets are larger than current liabilities. The next check you should do with the balance sheet is to look at the level of its working capital. The working capital of a firm can be worked out by taking the current assets (not the fixed assets) minus the current liabilities. If this is low or negative, then your firm may have cash flow problems. Other areas to check include:
- High borrowings relative to the firm’s share capital and reserves
- Negative cash flow or persistent long-term cash flow problems
- Debtors rising faster than turnover
- Large amounts of working capital tied up in work-in-progress
- High levels of written-off bad debts
- Net current liabilities where the firm has short-term debts greater than its readily realisable assets
- The sustainability of current levels of partners’ drawings.
Get external independent advice
If you are concerned about anything financially related then talk with the Finance Director in your firm, and get an independent accountant to review the accounts for you.