Insolvency: The technical definition

The Insolvency Act sets two benchmarks for corporate insolvency:

  • When a company cannot pay its debts as they fall due (known as the ‘cash flow’ test)
  • When a company’s liabilities (including contingent liabilities) are more than the value of its assets (known as the ‘balance sheet’ test)

What does this mean in the real commercial world?

These definitions might force a huge number of viable companies into insolvency if they were taken at face value, but they remain a good guide for businesses with vulnerable finances. Fortunately, legal precedents and pragmatic commercial judgments have put common sense flesh on these bare legislative bones.

Cash flow insolvency

The original definition has been broadened by a series of court decisions, so that the broadly accepted test now is not that a business cannot pay when its liabilities are due, but instead when they are demanded. This allows negotiations with creditors to take place for deferred settlement or payment by instalments, a commonplace occurrence for example with HMRC for example.

A further consideration has also been developed, where directors are now expected to look forward twelve months in considering not just whether they can pay debts now, but in the future. Some years ago, a major furniture retailer opted to go into Administration just after Christmas despite having several million pounds of cash because it knew that it would be unable to pay for the new stock it required for the next peak sale season a few months ahead. This is sometimes referred to as the ‘going concern’ test.

Despite these issues, if a business cannot pay its debts as demanded and cannot raise the necessary additional finance to do so, it is insolvent.

Balance Sheet insolvency

Companies with negative balance sheets filed at Companies House are ten a penny. 9% of construction companies are ‘zombies’ with greater liabilities than assets, as are 18% of retailers and a whopping 27% of hospitality businesses. The real question is why? A small percentage have so-called private equity funding structures, where they have been loaded with debts, which only need to be repaid under certain limited circumstances. Many more are financed by directors’ loans, rather than by share capital, meaning that the excess debts are unlikely to be called in.

The problem companies are those that do not fit these profiles; they are being propped up by lenient creditors and talk of better times ahead by their owners. Sometimes, they are sustained by showing a decent profit or strong turnover growth, which may dissuade overdue creditors from taking enforcement action, but which just suck in more working capital and debt.  If the only thing supporting an insolvent business is the hope that something will turn up, the reality is probably the polar opposite and the liabilities will eventually overwhelm it, but usually through the route of a cash flow crisis.

Pandemic impact on business

For many directors, the crisis has been a distinctly mixed blessing. It has brought them business interruption on a scale last caused by WW2, but the plethora of government support schemes has also provided substantial cash flow relief. There have been months of furlough cash on offer to reduce staff costs, VAT payments have been deferred, in certain industries there has been a whole year’s business rates holiday, landlords have been unable to enforce overdue rent for many months and banks have been throwing no-questions-asked soft loans at willing borrowers like confetti at a wedding.

Sadly, there is a reality check coming soon and for some businesses, the most painful of reckonings. Liabilities have been postponed, but they have not gone away. Some experts predict that as many as half of the Bounce Back Loans will default; others are forecasting an explosion of company insolvencies to record levels in 2021. As that furniture retailer recognised, being able to pay your debts now does not necessarily mean that your business is solvent.

The downsides of ignoring the warning signs of insolvency

It is not just creditors who pay a price if a company trades on past the point of insolvency. There is a range of painful potential penalties for the directors too, including wrongful or fraudulent trading and making preferential payments. There is also the spectre of being disqualified from taking any active role in the management of a company for up to fifteen years. Wrongful trading laws may have been put on ice temporarily by the government during the pandemic, but soon enough they will be back to haunt irresponsible directors.

What to do if insolvency looms

This is a highly technical question, so getting expert professional advice at the earliest stage is essential.  This will not only clarify whether the company really is insolvent, but it will also enable the various options available at the point of insolvency to be explored and the proper action taken, depending on all the circumstances.

If you are concerned about insolvency looming, we are here to help. We don’t judge, our ethos is to listen, understand and offer solutions. If you would like to have a confidential, non-obligatory chat with one of our Partners, about your business, please contact one of our Partners at your nearest office.

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