What is Insolvency

Here you can download our What Is Insolvency bookelt. An example of the useful information you can find in the booklet is featured below.

 

Introduction

Insolvency is classically a measure of either the net assets an individual or company owns, or the ability of that individual or company to pay its debts as and when they become due. This booklet addresses corporate insolvency, i.e. as it relates to companies, and the various mechanisms that exist under UK legislation to deal with company insolvency. For information relating to personal insolvency, please review our other booklets available to download on our website.

Just because a company is technically insolvent doesn’t necessarily mean the end of company’s life. There are a range of options open to help businesses in difficulty, such as refinancing and restructuring. Many companies in the UK are insolvent but with the right assistance can recover and thrive.

However, as a director of a business it is vital to understand the issue of solvency and this booklet helps explain the two main tests of insolvency and what can be done to assist you if you are concerned.

How do I know if a company is technically insolvent?

There are two main tests to determine whether a company is insolvent:

  • The Balance Sheet Test.
  • The Cash Flow Test.

These will now be explained below.

The Balance Sheet Test

This test determines insolvency as where the value of a company’s assets are less than the amount of liabilities, taking into account its contingent (i.e. not yet due) and prospective (i.e. those which are intended to be incurred very soon or which accrue as a fixed ongoing cost of the business e.g. utilities) debts.

This calculation can often be difficult to make for a director to make as that person has to decide and agree the basis on which assets and liabilities are valued. This is especially true if a director does not have much financial expertise. However, getting this right is critical to determining the true position of a company’s solvency. There are numerous factors which might affect the balance sheet test which are not immediately obvious – some examples of which are set out below.

Example 1.

If an outstanding debt which is quite large is shown in the company’s accounts, but is unlikely to be paid, then accounting standards require that directors be prudent and include a provision for the loss of this debt. If a large debt is not so provided for in the accounts then, in certain circumstances, this may mean that the company is actually insolvent (if the debt should be provided for as a write off).

Example 2.

Quite often an optimistic director will be convinced that the company is not insolvent because of anticipated funding, either from a lending institution or third party. If such lending is not yet secured (despite the verbal or other assurances that are provided) then the company may be insolvent with the consequences for directors (for more details see “Directors and Liabilities: A Handy Guide” also located on our website).

Example 3.

As with book debts described above, any asset that is valued in the company’s accounts but which may have depreciated since (for example plant and machinery) will mean that the company is balance sheet insolvent, even if the financial accounts do not reflect this. In more recent times, the reduced value of commercial property may also have a similar affect to make a company insolvent.

Example 4.

Pension scheme deficits are often undervalued because the basis of a valuation may be outdated or may be not up to the current accounting standards. A revaluation of the pension scheme deficit on a regular basis is important to ensure that the financial statements of a company reflect the true and fair view of the company’s financial position.

Example 5.

A company’s accounts are normally drafted on the basis that a company is an active going concern. As a result there may intangible assets valued in these accounts which depend on this going concern basis (for example goodwill, trading names and other intellectual property of the company). If the company is then facing difficulty in continued trading or something changes which means that its going concern status is jeopardised (for example a change in regulations affecting the business or the inability to renew a franchise licence) then the balance sheet needs to be valued on a break-up basis. This may reduce the value of the company’s balance sheet and mean that it is insolvent.

IN ORDER TO FIND OUT MORE ABOUT THIS SUBJECT AND THE ANSWERS TO THE QUESTIONS LISTED BELOW, DOWNLOAD OUR HANDY TIPS BOOKLET HERE.

ALTERNATIVELY, CONTACT THE TEAM ON 020 7841 0390

The Cash Flow Test

The Responsibility For Getting This Right

Getting It Right

If you believe your business is experiencing one or more of the above issues, or if you have any other business concerns that you would like to discuss please do not hesitate to contact us.

Should you require any further assistance at all with these matters, then please contact one of our corporate specialists on 020 7841 0390 and we will be happy to discuss this with you.