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.
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 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.
The Balance Sheet Test
Does the company’s debts outweigh its assets?
That’s the essential question posed by the balance sheet test. Simply list down all of your company’s assets in one column, and the contingent and prospective liabilities in another. If the value of the assets is lower than the liabilities, you are facing insolvency.
The Cash-flow Test
Can your company pay its bills on time?
This test accurately maps the amount of working capital you have available at any given time, comparing forecasted sales with payments that are due.
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:
- The cash-flow test.
- The balance sheet test.
- 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.
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
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.
The quickest way to duo this is simply to have a quick informal chat about your company and its options.