In brief - Well drafted trading and credit terms can help your company avoid bad debts
Seeking director's guarantees, following your credit policies and including recovery costs, interest clauses, general security and retention of title clauses in your trading terms can help you manage cash flow and prevent bad debts.
Company liquidation often due to poor management of cash flow
According to the Australian Securities & Investments Commission's report Corporate Insolvencies: December quarter 2014, in the second quarter of the 2014-2015 financial year, over 2,000 companies entered external administration. A major cause for companies entering external administration is poor management of the company's cash flow, in particular its accounts receivables. In addition to the risk of liquidation, lack of cash flow can lead to other problems such as:
- An inability to meet statutory obligations such as taxation liabilities and employee superannuation contributions
- Inability to pay creditors on time (and the imposition of interest and other charges and penalties)
- Poor credit rating
- Unwanted demands or court summons from creditors
- An increase in doubtful and bad debts
- Diminution of the company's value
Although there are often factors outside the control of the company that lead to its debtors being unable to pay their debts as and when they fall due, there are certain factors that a company can control, such as its trading terms.
Companies that spend time drafting proper trading and credit terms will enjoy more liquidity and fewer headaches when they have to recover their debts.
Seek director's guarantees and indemnities
Director's guarantees and indemnities are standard practice in many industries. A director's guarantee and indemnity is a legal undertaking, by the director of the company, that the director accepts personal liability for the debts of his or her company. Guarantees can also provide security over the director's property if drafted correctly.
In order for a director's guarantee to be effective, companies must ensure that the terms of the guarantee and indemnity are clear and reasonable and, if the guarantee seeks an interest over the director's private property, that the terms comply with the real property legislation in the particular jurisdiction.
Include recovery costs and interest clauses in your trading terms
A company wishing to pursue its creditors for debt should be able to recover its enforcement costs and charge interest for the period the debt has been unpaid. A good credit application includes indemnity provisions for the company's enforcement and recovery costs and a fair and reasonable amount of interest to be charged for overdue invoices.
Without such provisions, companies that are required to commence legal proceedings will be without grounds for seeking indemnity for their legal costs (which will result in the company's net return from the debtor being reduced) and will be forced to seek the default interest rate provided by legislation (which is often set at cash deposit rates). It is also important that these types of provisions are worded correctly so a court will not consider the interest clause to be a penalty.
Include general security and retention of title clauses
If a company wants to register an interest over its customers' personal property, over goods sold on credit or over hire equipment, it must ensure that the security clauses in its trading agreements (or the clauses in its separate security agreements) comply with the Personal Property Securities Act.
Companies must also ensure that they perfect their security interests by registering their interest on the Personal Property Securities Register as soon as possible.
Strictly follow credit policies and enforce trading terms
Debtors do not always pay their debts simply because a document obliges them to. A company must apply its internal credit policies and enforce its credit terms strictly to obtain the maximum benefit from them.
This includes ensuring that credit agreements are signed by the proper person or entity, that customer signatories have authority to bind their companies, that credit ceilings are enforced and trading halts are imposed when necessary.
By implementing these features in your business, you may prevent bad debt from being incurred and avoid having to write off debts due to lack of debt recovery options.
This is commentary published by Colin Biggers & Paisley for general information purposes only. This should not be relied on as specific advice. You should seek your own legal and other advice for any question, or for any specific situation or proposal, before making any final decision. The content also is subject to change. A person listed may not be admitted as a lawyer in all States and Territories. © Colin Biggers & Paisley, Australia 2023.