Insolvency is often used as a catchall name for companies in trouble, but there it actually means a very specific state of affairs.
It’s important that company directors understand the implications of trading whilst insolvent as wrongful and fraudulent trading both carry hefty penalties.
There are actually two legal definitions of insolvency; the’ balance sheet test’ and the ‘cash flow test’.
The easiest to understand is the cash flow test. This is simply where a company does not have enough free cash to pay its creditors when their invoices become due. It doesn’t describe very short term cash shortages but more a structural problem with meeting obligations.
As an example a firm may have no cash in the bank and invoice due to be paid in a week but on the other hand several customers who are due to settle tomorrow. This is a simple short term cash flow issue.
Conversely another firm may have £100,000 worth of supplier invoices to pay but only cash and invoices to the value of £50,000. In this case it would be wise to seek advice as to whether, under the cash flow test they are insolvent.
The balance sheet test describes where a company has total liabilities that exceed its total assets. Whilst this may seem an academic test, in fact it has direct implications for any supplier who provide good or service after the point of insolvency because it means that in the case of liquidation they are unlikely to receive their money.
Company directors are required under UK law to exercise reasonable care and skill in running the company. This means that ignorance is not a defence. You must make sure, even if you are not an accountant that you satisfy yourself you are not trading whilst insolvent.
The balance sheet test often requires specialist help to monitor. Balance sheet assets are often held at a historical cost and although they may strengthen the position of the company, if they are for things that have significantly reduced in value compared to their book value then a view may need to be taken.
Directors also need to project into the future because they should have a view as to whether the company is likely to fail either of the tests in the future.
There are a number of practical signs that a company may be about to fail the cash flow test.
Typically firms will begin to feel pressure from suppliers, being put on stop or required to pay for invoices in advance.
The average number of days until payment of invoices (known as debtor days) will lengthen and working capital will diminish.
Another sign that a company may be facing insolvency is when it misses deadlines for regular payments such as PAYE, VAT or Corporation Tax.
Finally there may be issues with paying staff on time, payroll may be short or staff may be unaccountably laid off or even CCJs and debt collectors arriving at the door.
If any of these things are happening in your company then you need to look carefully to see if you are failing the balance sheet or cash flow tests. If you are at all unsure then it is vital that you take advice from a qualified insolvency professional.