When a company gets into trouble it can be difficult to know when it is time to call a halt. Unfortunately the penalties for trading on when the business is insolvent can sometimes be harsh and directors need to make sure that they are aware of the problems that they may encounter.
Although sometimes misunderstood, in fact insolvency has a legal definition (or two).
The first is cash flow insolvency. This is perhaps the simplest to understand in that it simply means that the company is unable to pay its debts when due.
The second definition is balance sheet insolvency. This is when there is an excess of liabilities over assets. Although this might seem simple it can also include contingent liabilities which may contain an element of interpretation.
So why would it matter if a company trades whilst insolvent?
For directors knowingly trading whilst insolvent is an offence and can result in them being disqualified as directors and fined. Ignorance is no defence in this instance as the law requires directors to make themselves aware of the situation that the company is in and exercise the diligence of any ‘reasonably competent’ person.
By the same token, once a company goes into administration or liquidation the insolvency practitioner is charged with not only examining the conduct of the directors but also any transactions that may prejudice the interests of the creditors.
This means that in cases where directors have disposed of assets to connected parties, at a discount or have paid their own bills in preference to other creditors, the administrator or liquidator can reverse the transactions and make a report to the court.
So as we can see it is vital that directors have a handle on when the right time is to call in some expert help.
In the case of the cash flow test it’s fair to say that most companies at some time or another find themselves short of cash and temporary situations aren’t necessarily a sign of insolvency.
A company may find itself with restricted cash and unable to pay a bill or two whilst it waits for its own invoices to customers to be settled. The courts understand that this is the normal course of business and is not a sign of wrongful trading.
However when the gaps between the cash positive times grow longer and longer then the directors have to consider whether the situation is more than just a temporary blip.
The cash flow test can be seen as the short term symptoms of a long term problem and the balance sheet is that long term problem.
Any company can last forever as long as it has enough cash sitting on its balance sheet, but when the cash and the assets run low, that’s when problems arise.
In the case of the balance sheet test insolvency can seem more theoretical but it is just as important that directors are fully aware of the repercussions that may arise.
The test is initially simple – does the company have more assets than liabilities on its balance sheet?
The point of this is that should the company fold there will be enough assets to sell to cover any outstanding liabilities to creditors.
Again theoretically they can be any form of asset. So a company could have machinery, intellectual property or loans to debtors that could be sold or called in to pay off remaining creditors.
In practice it makes sense to match as far as possible short term (or current assets) to short term liabilities because a company that had a balance sheet full of long term assets (such as machinery) and short term liabilities such as PAYE,VAT and wages would find it very difficult to survive the cash flow test.
As we have previously said short term blips are acceptable. The problem comes when the blips begin to last longer and longer.
At this point the directors need to make a judgement – is there a reasonable prospect of the company trading out of its current situation?
When the company reaches this juncture there needs to be a heavy dose of realism. If you run a business then it’s important that you are a person with a positive outlook, but in the case of insolvency it really is vital that a cold hard look is taken at any rescue plan.
An argument could easily be made for a seasonal trading company that finds itself short of cash (think ice creams in February) but the same cannot be said for an engineering firm with few orders and no money to pay suppliers.
Directors should be able to show that they have a plan that is fully documented together with their thought processes (minutes of meetings are useful here) and that they have taken into account all aspects of the situation to come to their reasoned conclusion.
If you find your company in the situation where it does not have enough cash to pay its bills and/or has a weak balance sheet then it is important to ascertain whether your business has a realistic prospect of survival. If in doubt then directors should take the advice of a properly qualified insolvency professional to ensure that they are fully protected.