Directors have a legal duty to ensure that their company does not trade whilst insolvent but ‘insolvency’ can often be a confusing term. In this article we’ll try and give some clear guidance about what insolvency actually is and how you can test your company.
In UK law there are three tests that should be applied to see if a company is insolvent or not; The Cash Flow Test, The Balance Sheet Test and the Litigation Test.
The Cash Flow Test
The primary aim of insolvency legislation is to protect creditors of failing companies and to put the onus on directors to take action when they have a business in trouble rather than simply burying their head in the sand and incurring more debt.
The Cash Flow Test is a good example of this.
In this test the simple assessment is whether the company has a realistic prospect of paying its debts when they come due. So for example a business may be facing a short term cash flow crisis whilst they work on a large contract however they know that within the next 30 days the client will pay their invoice and the firm will be able to settle its own debts.
In this case the business would look a good prospect to continue and the cash flow test would suggest that they are not insolvent.
On the other hand if we imagine a business that has a large amount of assets on their balance sheet but are failing to meet payment deadlines with suppliers and HMRC, and they have no realistic prospect of either selling assets to raise cash or bringing in debt or equity finance then they would fail the test.
As the legal embodiment of the saying ‘cash is king’ the cash flow test is a codified method of ensuring that businesses don’t continue when they have no working capital with which to service their debts when due.
The Balance Sheet Test
This test can often be seen as a more technical accounting test but even so it is important that directors also bear it in mind.
The test is very simple in that it looks to see whether the assets shown on the balance sheet are more than the liabilities or not. If liabilities outstrip assets then the firm is technically insolvent.
Of course life is much more complex than that and as the UK Supreme Court has ruled, the balance sheet test cannot be applied literally.
There are other items which provide context that also need to be added to the mix.
If we take our fictitious company that has liabilities that are larger than its assets a simple reading may suggest that it is insolvent. However if a large part of the liabilities are long term loans, on favourable terms from the directors or owners of the company then it is a fair argument to make that they are unlikely to be defaulted and instead the cashflow test should be applied to current liabilities instead.
Alternatively a business may appear to be solvent as in our example in the cash flow test with assets that are larger than its liabilities but if all of the assets are fixed and all of the liabilities are current and payable then the balance sheet test provides less help.
Again the Supreme Court provides some guidance in its direction that it needs to be considered whether the business has reached the ‘point of no return’. In other words, whatever the balance sheet situation, is it likely that there will be a favourable outcome or is it conversely the case that as it is currently trading it will never return to a positive balance sheet.
When assessing insolvency the court will also have to take into account any contingent assets or liabilities.
A contingent liability (or asset) is one where a liability may arise as a consequence of some future event.
For example if a company is facing enforcement action from a regulator as in the recent Prodial Ltd case, then the liability is contingent upon the regulators finding against the firm. If there is a good prospect that a large fine will be levied which putting the company into an insolvent position then this will need to be taken into account.
Similarly if the directors have recognised a contingent asset without which the company would be insolvent then advice will need to be sought as to the specific situation.
The litigation test
Again this is a fairly simple test.
Has the company received a county court judgement or have they been served a statutory demand? If they have, and if they are unable to settle them then there is a case for insolvency.
The above examples are very general in nature and as we know businesses, and the situations they face are all different.
Getting specific advice regarding your own individual case is vital for directors who have any concerns whatsoever about the solvency or otherwise of their company so speaking with a licensed insolvency practitioner is of paramount importance.