What is the Insolvency Test for a UK Limited Company?

The Insolvency Test for corporate entities refers to a method of determining a company’s ability to meet its liabilities as they fall due, and whether the total value of its liabilities exceeds assets. 

The three individual tests for insolvency should be viewed together to gain a reliable picture of the company’s financial position, and are designed to trigger the appropriate actions should insolvency be the result.

Maximising creditor interests must be the principle focus if results indicate insolvency. You could face investigation as a director if you continue to put your own or shareholder interests first. Insolvency is when when a company’s debts outweigh assets or if the company cannot pay its bills when due.

In this article we’ll explore what it means, and the implications for your limited company.

What is the Insolvency Test?

The insolvency test in short refers to a number of tests that are required to determine the financial standing of a business.  Insolvency determines whether the company assets are less than its liabilities. If the company liabilities exceed those of company assets, it’s possible that your company could be on the verge of insolvency.

In order to establish if your company is insolvent you need to apply the 3 tests for insolvency that will determine if your company can pay its liabilities and be viable in the future. Look at the tests for insolvency below which will tell you whether the company is insolvent or not.

Test for Insolvency

Known in accounting world as the acid test or quick ratio, there are two simple tests to assess whether your company is insolvent. Of these two company insolvency tests, the cash-flow test is probably the most important as you can have all the assets in the world, but if you cannot pay your bills on time you may find yourself forced into liquidation. An angry creditor (someone you owe money to) only needs to be owed £750+ to be able to force your company into liquidation by the use of a winding up petition.

You can usually tell that your company is insolvent because if you are being chased for payment from suppliers and cannot afford to pay them on time or if you have asked to defer payments such as PAYE or VAT. 

However, your company may be insolvent without even realising it. There are two main legal tests to decide if you are insolvent. The importance of these tests is that they are the legal tests and define the point of insolvency and when your duty of care moves from being owed to members to being owed to the creditors first.

If you treat creditors badly and let the financial position get worse, you could be accused of trading whilst insolvent, which then could lead to a you being made liable for wrongful trading or a misfeasance claim. A misfeasance claim is a catch-all claim for breach of your duties as a director sometimes brought by a liquidator to recover funds for creditors. You should always have those duties in mind (see sections 171-177 Companies Act 2006)

How do you Determine Insolvency?

The insolvency test refers to three simple checks to determine the insolvency status of a business, or individual. In this case, we have focused on the insolvency status of a business.

The three checks that the insolvency test covers are as follows:

1. The cash-flow test.
2. The balance sheet test.
3. The legal action test.

The Cash-flow Insolvency Test?

The cash-flow test is designed to find out whether a business can pay its bills when they fall due. This test isn’t simply about can you pay your bills at this exact moment, either. The legal requirement is that you are able to pay your bills in the ‘in the reasonably near future. An inability to pay bills as they fall due is a clear sign of your company’s precarious financial situation. Furthermore, a requirement exists to consider whether you can pay bills ‘in the reasonably near future.’

You could be facing the prospect of company insolvency due to a lack of working capital, thus affecting the cash flow. Keeping a close eye on your business cash flow is integral to directing a company. You should be running and regularly updating a successful cash flow model to ward off company insolvency.Simply – can the company pay its debts when they fall due?

The cash flow test looks at whether a company can pay its liabilities as and when they fall due. When doing this test you should look at your company’s current financial obligations and any which will be due in the near future. If your company is unable to meet these day-to-day costs then you should make it a priority to enlist the help of a professional before your situation spirals out of control.

What Qualifies as Insolvency? – If your business cannot pay its bills on time, the chances are that it is mostly likely insolvent.

The Balance Sheet Insolvency Test

This part of the test aims to determine whether the value of the business’ cash at the bank, as well as the total value of assets combined, are more or less in value than the total value of liabilities that the business has. The balance sheet test is one you will ideally look at in conjunction with your accountant as these figures must be accurately and clearly represented.

A ‘fair and accurate’ view of the company’s current and future financial position should be reflected in the balance sheet, and must include all contingent liabilities. Items such as work-in-progress and levels of stock must not be overstated, nor should debts owed to the company that are unlikely, in reality, to be collectable.

The biggest risk for directors in insolvency is the accusation of wrongful trading which means you placed any interest ahead of creditors once you became aware of your financial position. This means you can’t pay yourself, any stuff, or even one supplier over another. Your responsibility is to the group of creditors as a whole and you need to be able to demonstrate that.

If you are in any way uncertain, it’s worthwhile to get professional help when establishing whether the company is insolvent. You could come to the wrong conclusion and see a positive outcome, when you are actually facing company insolvency. If this is the case and you continue to trade, you could face a larger problem if you are found to be wrongfully trading while insolvent.

So work through the balance sheet test carefully and, ensure you’re working with an accountant you trust.

What qualifies as insolvency? – If the total value of assets and cash combined has a value that is less than the total value of liabilities under the business name, chances are, it is insolvent.

The Legal Action Insolvency Test

The final part of the test aims to highlight whether any legal action has been taken out against the business for any debt to the value of £750 or more. This refers specifically to Statutory Demands, or County Court Judgements, both of which are the classic precedents to a winding up procedure. If a County Court Judgement has been upheld against the company, or it has failed to pay a Statutory Demand for Payment of a debt exceeding £750, it is likely that the company will be forcibly wound-up.

Multiple unpaid County Court Judgments (known as CCJ’s) are a very good indicator of failing the cash flow insolvency test. This is known as the legal action test. This evidence is often used by the Insolvency Service to disqualify directors.

What qualifies as insolvency? – If your business has had legal action set against it of this value of debt or greater, your business may be insolvent.

Warning signs that your company is insolvent?

There are a few indicators you need to watch out for to establish insolvency. These would include:

• Does your monthly balance sheet, if you use an accounting software package, show total liabilities exceed total assets?
• Your annual accounts show total liabilities exceed total assets. Your accountant will draw this to your attention, and you can no longer pay dividends.
• Your company receives a qualified audit report stating that you are at risk of no longer being a going concern.
• You need to ask creditors like HM Revenue and Customs for time to pay.
• You receive telephone calls and late payment letters from creditors as you are often late to pay them due to a lack of funds.
• You are taken to Court for non-payment by creditors.
• Your bank withdraws funding on your overdraft facility or calls in loans.

Lastly, you may be solvent now but be able to predict probable insolvency in the future. A good example would be the loss of a major customer. A cash flow forecast should be able to help with some projections.

What options are available?

Being insolvent is not an untenable situation. Various options remain that could rescue the business if it is deemed viable, or release cash through consolidation of debt. A licensed Insolvency Practitioner would need to identify your options depending on the company’s current financial position, actions that creditors are likely to take, and whether there are any outstanding statutory payments. If you believe that any of the above tests are positive for your business, it is vital that you and the board of directors take action to address the insolvent position.

It’s very important that you do not just carry on as normal and let the financial position deteriorate – at worst you could be personally liable for the debts. You need to find out if the business can be turned around or if the financial problems are terminal. The quickest way to duo this is simply to have a quick informal chat about your company and its options.