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How to identify an insolvent company

Directors have a legal duty to ensure that their company is not trading whilst insolvent.  But what does “trading insolvent” really mean, and how can it correctly be identified?  This month’s article provides an overview of the insolvency tests that can be applied to help company directors make an appropriate assessment of the situation.

There are three tests which are used to ascertain the extent of a company’s insolvency:

  1. The Cash Flow test – Can the company pay its debts as they fall due?
  2. The Balance Sheet test – Are the company’s assets greater than its liabilities?
  3. The Legal Action test – Has a creditor successfully taken legal action against the company?

Insolvency legislation is in place to protect creditors of failing companies, and the onus is on directors to act in a responsible manner and take action when their company fails at least one of these tests.  Directors therefore must act to maximise creditors’ interests, and failure to do so could lead to personal liability for the directors.

Let’s start by looking at each test in more detail:

The Cash Flow Test

This test is to establish whether or not a company has a realistic prospect of paying its debts as and when they fall due.

For example, if a business is facing a short term cash flow issue while working on a contract, but they can service their liabilities once that contract is paid, then it would pass the cash flow test and not be classed as being insolvent.

However, a business that has a large amount of assets on their balance sheet, may look solvent and in a strong position, but if it fails to meet payment deadlines to suppliers and HMRC, and has no realistic prospect of selling assets to raise cash, it would fail the test.

Cash is king, so businesses with little or no working capital with which to fully service debts must take corrective action, or cease trading to avoid a worsening situation.

The Balance Sheet Test

This test is to establish whether the value of a company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities (a contingent liability being one which may arise as a consequence of some future event).

It may seem like a simple accounting test, but it can be more complex than that.  For example a business with liabilities larger than its assets may look insolvent, but if the liabilities are long term loans on favourable terms, then you could argue that it isn’t in an insolvent state.  You would still need to apply the cash flow test to confirm this.

A key consideration is the extent to which the company’s assets might be realisable, and for what amount – it is not simply a question of looking at their current book value.  For example, Goodwill on incorporation or in relation to leasehold improvements is unlikely to be an asset that can be sold to raise funds, whereas a stock holding might be.  When making an assessment it is also important to account for items that may be overstated, such as obsolete stock, work in progress and book debts which can’t be collected.

The Legal Action Test

If a creditor has taken legal action like obtaining a County Court Judgment (CCJ), this may demonstrate the company’s insolvency and the creditor might petition to wind up the company (compulsory liquidation).

If a creditor has obtained a statutory demand which remains unpaid for more than 21 days, then the creditor may petition to wind up the company.  But in fact any debt over £750 that is not in dispute can result in a winding up petition being served, and the creditor doesn’t need to issue a statutory demand beforehand.

In many respects the Legal Action test is merely an extension of the Cash Flow test, since it relates to action a creditor might take when payment to them is overdue.

What Happens if a Company Fails One or More of the Insolvency Tests?

If one or more of the tests have failed then the directors should seek professional advice, either from their accountant or from an insolvency practitioner.

Failing an insolvency test does not necessarily mean that the company needs an insolvency solution – but what it does mean is that the directors need to take some form of direct action to address the issue.  There are numerous options, depending on the scenario, but some of the most frequent ones are:

  • An injection of cash into the business (e.g. business loans, directors loans, factoring)
  • Agreeing payment arrangements with creditors which are affordable, based on cash flow projections (and which don’t result in further arrears)
  • Actions to improve profitability and cash flow (e.g. cost saving measures)
  • A sale of surplus assets to raise funds to support cash flow

However if the directors are unable to address the situation through such actions then it is likely that an insolvency solution will be required.  The 2 most likely outcomes are a Company Voluntary Arrangement (CVA) or a Creditors Voluntary Liquidation (CVL) and you can visit our Debt Advice pages to read more about these solutions.

We hope this overview has been helpful.  If you would like more information, or have a client who may need our services, please don’t hesitate to contact me on 0115 871 2921 or by email aftab.zahoor@bridgewood.co.uk.

Bridgewood is one of the leading debt solutions firms in the Midlands, delivering value for money solutions with a compassionate and supportive approach.

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