If ignored, the early signs of company insolvency can, at worst case, result in the winding up of a company. Generally speaking, signs of insolvency might include company cash flow problems, maximum borrowing, creditors submitting a winding up petition, late payments and director pay freezes. If you believe your business could be heading towards insolvency, the cash flow test and balance sheet test can be used to determine company insolvency.
For more information on the early signs of insolvency, you can read up on our comprehensive guide.
What is balance sheet insolvency?
In short, balance sheet 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.
What is the balance sheet insolvency test?
The balance sheet tests deem a company insolvent if it shows negative shareholders’ funds. If your company liabilities outstrip the company assets, you are technically insolvent. However, if you have positive shareholder’s fund, your business can still be considered insolvent.
An accurate balance sheet insolvency test should include future and contingent liabilities. For example, deferred payments or potential litigation decisions, against the company. This is to ascertain a true and accurate assessment of the company’s state of affairs.
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.
A more straightforward and regular test that can be applied, is the cash flow test. This is often applied to the company before the balance sheet test.
What is cash flow insolvency?
According to the terms of the Insolvency Act 1986, the cash flow test is the second process in deeming whether a business is insolvent. The cash flow test analyses your ability to pay your company’s debts as they fall due, or in the very near future (dependant on your business). If you are frequently missing payment deadlines, that can be a sign of insolvency.
What is the cash flow test?
Cash flow tests are easier to understand than balance sheet tests, and perhaps more important. The cash flow test looks at how and when you can pay your debts. If your business is unable to pay creditors or suppliers, it’s likely the company lifespan will be relatively short.
If your company cannot pay its bills, now or in the near future, you risk an unpaid creditor issuing a winding up petition. The term ‘near future’ varies according to different industries, and other circumstances that might factor. However, the aim of the cash flow test is to protect creditors and put the onus on the directors, and the cash flow test is a good example.
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.
Should you be presented with a winding up petition, demonstrating your creditors are taking serious steps to close down your company, you need to seek urgent advice. If you are looking at how to stop the winding up petition, you can do so with our relevant post.
If you believe you may be facing the threat of insolvency, or need to seek advice regarding a balance sheet test and cash flow test, our business rescue experts are here to provide you with advice and help with the process.