The answer to the question “How do you determine if a company is insolvent?” is important because there are serious consequences for a director if debts are incurred after the company has become insolvent, including civil penalties, compensation proceedings and criminal charges. However, it is often difficult to know when a company has crossed the line from having a cash flow issue to becoming insolvent.
In this article, we look at the legal tests and indicators of insolvency, which provide a useful checklist for companies faced with financial difficulties.
Legal tests for insolvency
The definition of insolvency is set out at section 95A of the Corporations Act 2001 (Cth) which states as follows:
- A person is solvent if, and only if, the person is able to pay all the person’s debts, as and when they become due and payable.
- A person who is not solvent is insolvent.
Answering the question of whether a company is able to pay all of its debts as and when they become due and payable is not straight forward. The Courts have considered the operation of section 95A and set out a number of indicators of insolvency, which we examine below.
Indicators of insolvency
The indicators of potential insolvency include:
- Continuing losses: insolvency results from a combination of losses and insufficient working capital. Making continuing losses is a red flag to company directors of the possibility of insolvency.
- Liquidity ratio below 1: a liquidity ratio is determined by dividing the total liquid assets by the amount of short term borrowing, which shows whether the short term liabilities are covered.
- No access to alternative finance: A company with insufficient cash to pay its debts, must raise extra money to stay solvent. An inability to re-finance with a bank or raise equity indicates a lack of confidence in the company’s viability.
- Issuing post-dated/dishonoured cheques: this is evidence that a company does not have capacity to pay its debts which are due.
- Payments to creditors of rounded sums: this is a sign that a company is making payments based on the cash available at the time, and that the company cannot pay all its debt.
- Overdue tax remittances: withholding payment of tax commitments is often seen as the easiest way for a company to preserve cash flow in the short term and is a strategy adopted by companies in financial strife.
- A lack of timely and accurate financial information: a business’ ability to maintain accurate and organised records is a good indication of its wellbeing.
- Poor relationship with bank: banks are able to see a company’s financial transactions and cash levels. As such, they are well placed to be able to assess the financial position of a company. If a bank fails to extend further credit it indicates the bank does not consider the company to be financially sustainable.
- Suppliers placing the debtor on “cash on delivery” (COD) terms: this indicates a deterioration of the company’s trading relationship with its suppliers.
- Creditors issuing demands or legal proceedings: demands or legal proceedings are a major concern as they can give rise to involuntary liquidation and should be closely monitored.
If your company displays a number of the above indicators, then there is a possibility that your company is insolvent. If that is the case, we recommend that you seek immediate advice on your options from a lawyer or accountant.
If potential insolvency is identified early, a professional advisor may be able to assist your company in avoiding business failure. Steps should not be taken to place your company into voluntary administration or liquidation until you have received advice about the financial position of your company.
If you or someone you know wants more information or needs help or advice, please contact us on 1800 640 509 or email firstname.lastname@example.org.
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