The Insolvency Act 1986 provides two tests for insolvency:
If a company is deemed to be insolvent as a result of failing either test, the directors should seek professional advice from a Licensed Insolvency Practitioner to clarify their situation and determine an appropriate course of action. Taking advice is a positive step and will not necessarily lead to the Company being liquidated. The earlier that an Insolvency Practitioner is approached, the more options there are available to them. For example, refinancing options or ways in which to reduce business debt.
Directors have a duty to minimise losses to the company creditors; therefore, they shouldn’t continue to trade unless they have good reason to believe that the company will return to profitability and be able to repay creditors.
Failure to do so may lead to the directors being disqualified from acting as company directors in future, or even becoming liable for the debts of the company.
The Cash Flow test
- The cash flow test checks whether the company can meet its obligations, i.e. whether it can pay its debts as and when they fall due.
- This is a relatively simple test, with an easily identifiable outcome. A company director has a legal obligation to understand the company’s financial position and should know whether the business is comfortably able to meet its liabilities…or whether it’s facing pressure as a result of them.
The Balance Sheet test
- The balance sheet test reviews the assets and liabilities of a company. If the total asset value is less than outstanding liabilities, the business is considered insolvent.
- Contingent or prospective liabilities should be included within the test. For example, if a decision is imminent in respect of ongoing Court proceedings, and a liability is likely to arise as a result, a sensible estimate of this liability should be included.
- It is important to be prudent when reviewing a balance sheet; the risk is that a ‘solvent’ balance sheet may include items that are overstated, such as work in progress, or debtors which are unlikely to be realised. This is something to consider when you are drafting your accounts, as you are legally required to present accounts that show a true and fair picture of the business.
- You may review the balance sheet and decide that the company is not insolvent therefore they do not need to act. However, under the cashflow test above the company may still be insolvent. So you must act if it is.
If you would like any more information about cash flow/balance sheet tests, or if you are at all concerned about insolvency, please do not hesitate to contact us. We will gladly hold a free, no obligation meeting to discuss all your options.