Understanding the cash flow and balance sheet insolvency tests
If your company is experiencing financial difficulties, it is important to determine the extent of the problems being faced so that a plan can be put in place to turn the situation around. One of your first steps should be to ascertain whether the company is solvent or insolvent.
There are two main ways to determine a company’s solvency. These are known as the insolvency tests:
- Cash flow insolvency test – A company is said to be cash flow insolvent when it is unable to pay its debts and liabilities as and when they fall due
- Balance sheet insolvency test – A company is balance sheet insolvent when its debts and liabilities are greater than its assets
It is possible to be either cash flow insolvent or balance sheet insolvent; in many cases an insolvent company will be both.
What is the difference between balance sheet insolvency and cash flow insolvency?
While both tests are useful in establishing a company’s financial health, the cash flow insolvency test looks at the short-term position, while the balance sheet test takes a long-term view.
- Cash flow insolvency - There will be many warning signs that a company is cash flow insolvent, from being unable to pay its bills, through to creditors threatening further action and an inability to obtain additional credit. A cash flow insolvent company will find it increasingly difficult to continue to trade and its directors are likely to be all too aware of the precarious position it is in.
- Balance sheet insolvency - A company which is balance sheet insolvent may be able to meet its monthly liabilities and other overheads with ease; due to this, balance sheet insolvency can go undetected for some time. This type of insolvency is often caused due to increased business debts even if this is manageable on a month-to-month basis.
While balance sheet insolvency may not seem as serious as cash flow insolvency at first glance, creditors can still take action to wind the company up if they have reason to believe it is insolvent. Balance sheet insolvency threatens the long-term viability of the company, and if assets begin to decline in value without liabilities being significantly reduced, the company can quickly be taken past the point of rescue.
What happens after the insolvency tests?
The outcome of the two insolvency tests can have a significant impact on the future direction of your company. If either test determines that the company is insolvent, you have an obligation as its director to take action to address the situation.
Once you become aware your limited company is insolvent, you should seek the advice of a licensed insolvency practitioner as a matter of urgency. An insolvency practitioner will help you understand your current position and explore the various options open to you which could restructuring the company via administration, entering into negotiations with creditors by way of a Company Voluntary Arrangement, or placing the business into voluntary liquidation if it is beyond rescue.
The insolvency tests show my company is insolvent – what now?
In many cases you will need to cease trading immediately in order to protect the interests of outstanding creditors and shield them from suffering any further losses. In other situations, however, continuing to trade may be advised if it is decided that this will increase creditor returns. This decision can only be made by a licensed insolvency practitioner; directors who trade on while knowingly insolvent without taking expert advice, open themselves up to allegations of wrongful trading.
If you believe your company is insolvent, or is in danger of soon becoming insolvent, you should make it a priority to seek the services of a licensed insolvency practitioner. At Scotland Debt Solutions, our insolvency practitioners are licensed to act in Scotland and can provide you with all the information and guidance you need to decide on a route forward. Contact our team today for immediate help and advice.
