Directors have a legal duty to ensure that their company is not trading whilst insolvent. But what does “trading whilst insolvent” really mean and how can it correctly be identified? This 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 two statutory tests which are used to ascertain the extent of a company’s insolvency:
- The Cash Flow test – Can the company pay its debts as they fall due?
- The Balance Sheet test – Are the company’s assets greater than its liabilities?
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 protect creditors’ interests and failure to do so could lead to the directors becoming personally liable for a company’s debts when they knew or ought to have known it was insolvent.
Let’s start by looking at each test in more detail:
The Cash Flow Test
This test is whether a company is able to pay its debts as and when they fall due.
Examples of when a company might fail this test are:
- Failing to meet payment terms to suppliers, or pay PAYE/NIC or VAT tax when due
- Regularly breaching overdraft limits
- Bounced cheques
- Creditors commencing enforcement procedures
- Directors being unable to draw their usual salary
However if a business is simply facing a short term cash flow issue, say while working on a large contract, but it can service its liabilities once that contract is paid, then it would pass the cash flow test and not be classed as being insolvent.
In contrast, a business that has a large amount of assets on its 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 it is arguable that it is not in an insolvent state.
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 ageing, out of season, or obsolete stock, work in progress that cannot be completed and book debts which cannot be collected.
What Happens if a Company Fails One of the Insolvency Tests?
If one of the tests is 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, director’s loans, factoring)
- Agreeing payment arrangements with creditors which are affordable, based on cash flow projections (and which do not result in further arrears)
- Actions to improve profitability and cash flow (e.g. cost saving measures, or better credit control)
- 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 three most likely outcomes are Administration, a Company Voluntary Arrangement (CVA) or a Creditors’ Voluntary Liquidation (CVL) and you can read more about these potential solutions via the links below.
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