Picture the scene. You are the managing director or finance director of a once-thriving SME. In recent months your business's financial position has slipped and now alarm-bells are starting to ring. So what do you do? And where should you turn for advice?

The answers depend on the size and type of business you are running, and the nature of the problems it faces: perhaps it has begun to suffer quarter-on-quarter losses which, if sustained, will put its solvency in doubt; maybe input costs are outpacing revenues due to currency fluctuations; or perhaps new legislation means the business has to crystallise an unexpectedly large pensions deficit on its balance sheet.

Whatever the trigger, the important thing is to act quickly. As soon as you suspect that your business may be heading into potential insolvency territory, you should apply two solvency tests. The first is a cashflow test to ensure there is enough cash to meet debts as they become due. The second is a balance sheet test - generally a more complex exercise - to establish whether the assets exceed the liabilities.

These solvency tests may be critical not only to the business and its creditors, but to your personal liabilities as a director. If your business is simply underperforming and is not yet in any real danger of insolvency, the best approach may be to engage an experienced turnaround practitioner, probably a member of the Society of Turnaround Professionals (STP), a sister organisation to R3.

STP was set up in 2000 with support from the UK Government, financiers and leading accountancy firms, and its members are well-versed in helping companies improve their financial performance by taking on an advisory or executive role. By bringing in a turnaround professional at an early stage, many businesses successfully trade their way through their difficulties, while steering clear of any kind of formal insolvency process.

Directors' liability

However, the business's financial problems may already have gone too far for this approach. Again, the warning signs vary, ranging from the breaching of bank covenants to the serving of a winding-up petition. In such cases, you, as a director, must take a series of proactive steps to minimise the risk of personal liability. This is because, if the business slips into formal insolvency, the administrator or liquidator will assess whether the directors did everything possible to protect the interests of creditors.

The first move is to engage appropriate external professional advice immediately, including insolvency advice, both legal and accounting, from members of R3. Many directors are concerned about taking on the extra costs of this advice at a time when the business is struggling. But, if the worst happens, you can be sure the directors will be more heavily criticised for not having taken this step. Equally importantly, the right advisor can make the difference between a fresh start and a liquidation.

Protect your interests

Once they are on board, your advisers will guide you in protecting the interests of both creditors and directors. This includes ensuring that financial information is accurate and up to date, and is discussed at regular board meetings. If the right quality of management information is not available, then personnel and systems must be put in place to provide it. And the board of a company under financial stress should preferably meet face-to-face at least once a week, to show it is managing both the financial situation and ongoing business-as-usual.

Your board should also study regular forecasts of cashflows and shortfalls, and keep large creditors informed about any corrective restructuring or disposals. A general cost-cutting drive should include a moratorium on major new expenditure and a detailed review of third-party contracts. Directors may even show willing by reducing their drawings. If these actions fail to prevent collapse, then the board should have a solid fallback plan based on sound insolvency advice.

Throughout the turnaround process, your board should discuss in detail what advice has been given, how it has been implemented, and if not, why not. At each stage, the core requirement is to demonstrate and maintain confidence, backed by sound advice, that the business is viable in whole or in part.

The need for sound advice raises the question of what you should look for in a turnaround or insolvency expert. The rule here is 'horses for courses', since every business and its financial position are unique. The wealth of choice available means any business can tailor its advisers to its specific needs.

The choice should depend on the experience, size and fee scales of the available advisors. For example, a small local business would be unlikely to engage a global accountancy firm majoring in global restructurings. However, even small businesses may find it comforting to know that their regular accounting or legal advisors have insolvency practitioners in-house to help if necessary.

Financial difficulties can hit any business. For a director, the watchword is to get the right advice fast and not put your head in the sand. There are professionals readily to hand who can not only save your business, but improve it. If you fail to use them, you may ultimately have to answer to your creditors.

Patricia Godfrey is president of R3

Case study: Getting Northern Colour back in the black

The building and decorative paints and coatings manufacturer Northern Colour presents a fairly typical case study of a turnaround, according to Nick Ferguson, chief executive of the Society of Turnaround Professionals, which conducted the turnaround. When he was called in, he found a business whose brands occupied top quality and price position, but whose management was focused on building headcount and sales rather than cash and margins. As a result, the business was increasing its bank borrowings to fund working capital, at a time when the construction industry was entering a cyclical downturn.

With the banks threatening to pull the plug, the board became convinced that radical action was needed and appointed Ferguson. During a 12-month period the company cut its workforce from 480 to 240, paying redundancies with short-term loans, something the banks were prepared to provide since they could see the right steps were being taken. Northern Colour also sold little-used assets such as land, warehousing and distribution facilities, and changed its management culture from sales and size to profit and cash. This meant it effectively moved from being a bank borrower to depositor, while maintaining its premium price and quality position in the market, creating the efficiencies and confidence to enable renewed growth and investment.

Ferguson says the Northern Colour turnaround underlined the need for boards to move more quickly.

'Virtually every STP member will tell you that they have arrived in a business only to be told: 'you should have been here months ago,' he says. 'The later we get involved in a turnaround situation, the greater the pain and bloodletting. Management denial is often a fact of life, and it needn't be. In Northern Colour's case, the board could, and maybe should, have moved earlier, but at least it took action before the banks did it for them.'