It can sometimes not be clear and obvious whether a company is insolvent or not. Seemingly insignificant issues can cause business failure if they happen in conjunction with other similar problems.
The best way to determine if your company is insolvent is to apply the three tests for insolvency:
- Cash Flow
- Balance Sheet
- Legal Action
If your company fails any of these three tests your company is likely to be insolvent and you should seek professional advice.
Cash Flow Test
Simply enough, can the company pay its debts as and when they fall due?
If the company is suffering from poor cash flow you may be finding it difficult to meet payment terms with creditors. This includes things like failure to pay national insurance or income tax contributions for staff or directors. If this is the case your company is likely insolvent.
If you regularly pay creditors at a date later than agreed but they are happy with this arrangement then you may be able to argue that the conditions of your arrangement have changed, but you must be honest about whether this is truly the case.
You as a director have a legal requirement to understand this issue. You as a director have a legal duty to maximise creditor’s interests and if you believe your company cannot cover its liabilities you must take action.
Balance Sheet Test
Does the company owe more than it owns, or in other terms are the company’s assets exceeded by its liabilities? If the answer is yes, then the company is more than likely insolvent.
A court will determine if it expects the company to be able to meet all its liabilities in a reasonable time. If the court believes is can then it will not be deemed insolvent, but if the court believes it cannot insolvency proceedings must begin immediately.
Creditors hold the burden of proof for demonstrating insolvency. They will be attempting to institute a winding-up petition which will come into practice if they are successful. The court is not likely to wind up a company just for being balance sheet insolvent, but it will wind it up if they are unable to pay the creditor bringing the case. That in itself would be proof of cash flow insolvency.
Passing the balance sheet test is not absolute proof that your company is insolvent, it may still be cash-flow insolvent. In which case you may still need to take action to maximise creditor interest.
Legal Action Test
If a creditor has taken legal action and has obtained, or is likely to obtain, a County Court Judgment (CCJ) or a statutory demand against the company, this may indicate the company’s insolvency and allow the creditor to petition to wind it up.
Therefore, if your company has one or more CCJs and/or a statutory demand, it is more than likely insolvent.
If you believe that your company has failed any of the above tests, it is crucial that you take immediate action to address the company’s insolvent situation.
Directors of a company have a legal obligation to seek appropriate advice or take action if they believe the company has insufficient cash flow to pay its debts as and when they fall due.
If they don’t, then directors can find themselves personally liable for the debts that they have accrued since they should have taken those steps. The ‘Company Director Disqualification Act 1986’ deals harshly with directors who ignore the early warning signals and continue to trade.