Borrowing to survive? Understanding the implications of taking on debt during financial distress

When a business is under pressure, borrowing more can feel like the obvious way to buy time. But if the numbers do not support repayment, new debt can quickly create bigger problems for the company, its creditors and its directors personally.

For many directors, taking on additional debt can seem like a responsible decision. The business is under pressure, creditors are demanding payment, cash flow is tight, and a lender is prepared to provide funding. It seems sensible to accept that funding and allow yourself some breathing space to get the business back on track, right? Not always.

While additional funding can play an important role in achieving a successful turnaround, it can also significantly increase losses to creditors and expose directors to personal liability if the company is unable to repay its obligations. As insolvency practitioners, we regularly deal with directors who borrowed more money, genuinely believing that doing so would allow their business to recover. Some are right, but most are not.

What’s the difference between financial distress and insolvency?

Financial distress and insolvency are not the same thing. A business can be financially distressed, still trading, generating revenue and paying many of its bills, while showing serious underlying warning signs. Insolvency is what happens when that distress goes unaddressed.

Many people believe a company operates in one of two states: solvent or insolvent. But this disregards the messy grey area in between. A business may still be trading, generating revenue and paying many of its bills while simultaneously experiencing:

• Persistent cashflow shortages
• Creditor pressure
• Declining profitability
• Arrears with Inland Revenue
• Reliance on shareholder support
• Difficulty servicing existing debt

This period is what we refer to as financial distress. Make the right adjustments, such as increased capital or reduced expenses, and a business can be turned around and back into profitability. But ignore it, or fail to make the necessary changes, and this distress is just the first stop on the way to insolvency. At this stage, directors are often faced with a difficult choice:

1. Obtain additional funding, either through their own contributions or loans from third parties
2. Restructure the business to reduce expenses
3. Sell assets
4. Seek professional advice
5. Begin an orderly insolvency process

The temptation is usually to borrow more money and hope the business recovers. Unfortunately, hope is not a financial strategy.

The real question is not whether you can borrow, but whether you can repay

The real question is not: “Can we obtain finance?”

It is: “Can we realistically repay it, and what happens if we can’t?”

Lenders, finance companies, shareholders, directors and suppliers may all be willing to provide additional funding. However, their willingness to advance money does not mean the company can safely incur the obligation.

Before signing any new loan documents, directors should ask themselves:

• What is the purpose of the borrowing?
• How will the funds improve the company’s position?
• Do we have a reliable cash flow forecast that shows we can meet the repayments?
• What happens if revenue falls below forecast?
• Can the company survive without further borrowing?
• Is the debt funding growth or funding losses?
• Is the lender asking me to sign a personal guarantee to secure the loan, and how will that affect my personal position should the company default?

If the company requires new debt simply to meet existing obligations, directors should proceed with caution. Borrowing to fund ongoing losses does not solve the underlying problem if there is not enough cash flow to meet the day-to-day costs of the business.

Can a director be personally liable for company debt in NZ?

Yes, in certain circumstances. Limited liability protects directors from being automatically responsible for company debts, but it does not override their statutory duties. If a director breaches those duties, they can be held personally liable.

One of the greatest misconceptions among directors is that because a company has limited liability, they themselves cannot be personally exposed. While limited liability is an advantage of incorporation, directors still have independent statutory duties that can expose them to liability if breached.

When a company enters financial distress, those duties become increasingly important. Two provisions of the Companies Act 1993 are particularly relevant.

Section 135 – Reckless Trading: Directors must not allow the company’s business to be carried on in a manner likely to create a substantial risk of serious loss to creditors.

This does not mean every failed business has been recklessly traded. However, continuing to incur debt when there is no realistic prospect of repayment can put directors at risk of breaching this duty.

Section 136 – Incurring Obligations: Directors must not agree to a company incurring an obligation unless they believe on reasonable grounds that the company will be able to perform that obligation when required.

This provision becomes particularly important when:

• Signing new loan agreements
• Increasing overdraft facilities
• Accepting supplier credit
• Entering long-term lease commitments
• Purchasing stock on credit
• Entering financing arrangements

A director who authorises new borrowing without reasonable grounds for believing repayment is achievable may face scrutiny if the company later fails.

What did the Mainzeal case change for directors?

The Supreme Court’s decision in Mainzeal reinforced the importance of creditor protection when companies face financial difficulty.

One key lesson from the case is that directors cannot rely on optimism or assumptions that circumstances will improve. Directors must have a rational and reasonable basis for believing the business can continue trading without creating unacceptable risk for creditors.

In practical terms, that means:

• Proper financial information
• Reliable forecasting
• Regular review of performance
• Evidence supporting key assumptions
• Active management of financial risk

Wishful thinking is unlikely to satisfy a court.

Common warning signs of financial distress directors often ignore

Businesses rarely collapse overnight. Warning signs usually develop over months or even years, and an observant director should be watching for them.

Inland Revenue Arrears

One of the clearest indicators of financial distress is a company’s inability to meet its GST and PAYE obligations. This is typically the first sign of a distressed business. Given how easy it can be to put off paying current tax obligations and use those funds as working capital instead, it is easy to forget about the consequences and assume the money can be recouped and repaid in the long term.

While this may temporarily improve cash flow, it often signals deeper problems.

Increasing Trade Creditor Pressure

Suppliers demanding cash on delivery are usually reacting to concerns about recoverability. They have put up with delayed payment of their invoices for too long and are not willing to expose themselves any further.

When previously supportive suppliers begin tightening credit terms, directors should take notice.

Reliance on Shareholder Funding

Occasional shareholder support is not unusual. However, constant injections of funds just to meet day-to-day operating expenses may indicate that the underlying business model is no longer sustainable. The shareholder has to ask whether they are likely to get a return on those funds, or whether they are better off utilising them elsewhere.

Declining Working Capital

Many directors focus on profitability while overlooking working capital. A profitable business can still fail if it lacks sufficient cash to meet its obligations as they fall due.

Constant Refinancing

If every loan maturity requires a replacement loan, the business may have developed a dependency on external funding rather than generating sustainable cash flow.

What happens if I sign a personal guarantee and the company fails?

If a company with a personal guarantee attached to its lending fails, the lender can pursue the guarantor directly. That can mean personal assets, family finances and even retirement savings are exposed, regardless of the company’s limited liability.

Many lenders will only support distressed businesses if directors or other stakeholders are prepared to provide personal guarantees. Directors frequently underestimate the significance of this decision.

If the turnaround fails:

• The company may enter liquidation
• The lender may enforce the guarantee
• Personal assets may become exposed
• Family finances can be affected
• Retirement savings may be at risk

We regularly encounter directors who are more financially damaged by a personal guarantee than by the business failure itself. Personal relationships can also become strained as those obligations hit home, with personal property, such as the family home, on the line.

Before signing any guarantee, directors should obtain independent legal advice and carefully assess the downside scenario. They should also have open communication with their loved ones, so nobody is caught unaware if the situation were to turn bad.

A useful question is:
“If the company fails in 12 months, can I personally withstand enforcement of this guarantee?”

When additional borrowing may be appropriate

Additional debt is not always the wrong decision. In some circumstances, borrowing can be entirely justified but it needs to be backed by evidence, not hope.

Temporary Cashflow Mismatches
A profitable business experiencing a short-term cash flow issue may benefit from additional funding.

Clearly Identified Turnaround Opportunities
Borrowing may support a genuine recovery strategy where management can demonstrate:

• Future contracts
• Confirmed work
• Reliable revenue forecasts
• Cost reductions

Structured Restructuring Plans
Borrowing may form part of a broader restructuring process where there is a credible path to sustainability. The key distinction is evidence.

Directors should be able to articulate exactly why the additional debt improves outcomes for creditors, rather than increasing losses.

What questions should a director ask before signing a new loan?

Before committing the company to additional borrowing, consider the following.

Financial Position

1. Do we fully understand our current financial position?
2. Are management accounts current?
3. Have we prepared cashflow forecasts?

Creditor Impact

1. Will this borrowing improve creditor outcomes?
2. Or will it simply delay an inevitable insolvency?

Assumptions

1. Do my assumptions support repayment?
2. Are those assumptions realistic?

Alternatives

1. Have we considered restructuring?
2. Have we considered asset sales?
3. Have we considered professional advice?

Personal Exposure

1. Is a personal guarantee required?
2. What happens if the company cannot repay?

Decision Documentation

1. Have directors documented the reasoning behind the decision?
2. Is there evidence supporting the conclusion?

A properly documented decision-making process can be just as important as the ultimate decision itself.

Why do directors wait too long to get advice?

A director may recognise that the business is experiencing financial difficulties but believes the situation will improve next month. Or next quarter. Or after the next project. Eventually, options become limited, and the director no longer has a choice about which avenue to take, as the choice is forced upon them by a creditor.

Delay is one of the most common patterns we see.

The directors who generally achieve the best outcomes are those who do not gamble on recovery. They are the ones who confront problems early, obtain professional advice and make informed decisions while meaningful options still exist. Instead of relying on assumptions, they make calculated plans, supported by the right people.