How to Use the Corporate Insolvency Test for a Limited Company

September 11, 2023 / Business Insolvency

Insolvency is a financial state that indicates serious trouble for a company. Not only does it foreshadow severe financial turmoil for a company, but it also can cause directors financial and legal problems. As such, knowing whether your company is approaching insolvency can be invaluable.

Directors have a number of tools and warning signs they can turn to for solid information, with one of these tools being a corporate insolvency test for limited companies. 

In this article, Clarke Bell will focus on this test, providing an in-depth overview of what it is, how it works, and how you can put it to use.

What does insolvency mean for a limited company?

Insolvency is simply a term given to describe companies that cannot repay their debts when they come due. More specifically, a company with fewer assets than debts would be considered insolvent. In many cases, these problems culminate in the closing of a company, either voluntarily or involuntarily.

What is a corporate insolvency test?

A corporate insolvency test is not one singular test, but rather three separate components that can be used independently of one another. Each component measures a different part of a company’s situation, but with the same goal – to determine whether the company can expect insolvency in the near future.

Balance sheet insolvency test

The first component of a corporate insolvency test is a balance sheet test. This test requires directors to closely examine their company’s balance sheet. Directors must accurately identify their company’s assets and outstanding debts, as any misrepresentations will skew the results and give no actionable information. Directors should also take care not to count potential income that is highly unlikely to materialise, such as invoices that aren’t likely to be paid and cannot be obtained through other means.

At the end of this examination, directors should have painted a fairly clear picture of their company’s finances. If the company has more assets on the books than debts, it should be able to stave off insolvency for the time being. However, if the company’s debts outnumber its assets, then insolvency is on the horizon. 

Note that even if your balance sheet insolvency test shows that your company is solvent, this is no defence against claims of misconduct should your company later be shown to be insolvent.

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Cash flow insolvency test

The second component of the corporate insolvency test for a limited company is the cash flow test. Rather than considering your company’s finances as a whole, the cash flow test specifically looks at your company’s short-term incomings and outgoings. If your company is struggling to pay its bills, and debts due in the short term will be difficult to repay, your company will likely face insolvency soon.

Legal action insolvency test

The final component of the corporate insolvency test is the legal action test. This test is quite different from the other two, assessing whether a company has received legal orders to repay debts, and whether it can comply. For example, if your company has received a County Court Judgement (CCJ), or a Statutory Demand that it cannot comply with, then your company is in a grave position. 

Failing this test is a sure sign that your company faces insurmountable financial trouble, and you should cease trading immediately to put your creditors’ interests first. Failing to do so could result in accusations of misconduct and serious penalties thereafter.

How to use the corporate insolvency test for a limited company

Using the corporate insolvency test is, thankfully, quite simple. You should take any or all of the above tests and apply them to your company, ensuring you use the most accurate information possible. In doing so, you will obtain clear insight into your company’s finances, and whether you can expect insolvency in the near future. Each of the tests are quite obvious in terms of what data is required, and so using them is quite intuitive. The results of these tests will influence what your next steps should be.

If your company is found to be solvent, then staying the course is a perfectly good idea. However, if the tests indicate your company is about to face insolvency, then swift action is paramount. 

Trading while insolvent is an offence, one that is likely to lead to accusations of director misconduct and a slate of potential penalties. These penalties range from the disqualification of your director’s license for up to 15 years, fines, and in extreme cases, a prison sentence. 

Thankfully, there are options available to stave off the worst outcomes.

What you can do if your company is insolvent

If you find your company to be insolvent, you must stop trading immediately to focus on fulfilling your obligations to outstanding creditors. Failing to do so can result in the aforementioned penalties.

Directors of insolvent companies have two main options at their disposal – Creditors’ Voluntary Liquidation (CVL) and business rescue. Both procedures are viable methods of dealing with insolvency, but which one you choose will depend on the specifics of your situation and your preferred outcome.

Creditors’ Voluntary Liquidation

The CVL is a procedure for directors of insolvent companies with a range of benefits. It is a voluntary procedure, allowing directors to appoint an insolvency practitioner of their choice to the role of liquidator. This liquidator will take control of the company in order to carry out the CVL. They will identify any company assets, dispose of them for as high a price as possible, and distribute the proceeds amongst outstanding creditors. Once all distributions have been made, the company will be wound up and removed from the Companies House register. If any debts remain outstanding at this point, they will be written off, with the exception of those secured by a personal guarantee.

The CVL procedure offers several other key benefits, beyond an efficient method of closing an insolvent company. One such benefit comes in the form of legal protection. Namely, once a company is entered into a CVL, its creditors cannot take legal action against it. Essentially, this protects the company from being served a winding-up petition, and the compulsory liquidation that follows. The procedure also greatly reduces the likelihood that accusations of misconduct are made, and acts as a strong defence should any accusations reach the courts.

Business rescue

Although a CVL is an effective tool for insolvent companies, it isn’t always the right solution. For companies with a viable business model underneath their debt problems, a business rescue plan may be the preferable option.

Business rescue plans aim to restore an ailing company to profitability, though how this is achieved varies from company to company. For some, a business rescue plan will be a package of cost-cutting measures, while others will be cutting loose unprofitable segments of the company to focus on its strong suits. In any case, the end goal is the same – bringing a company back to profitability to the benefit of both directors and creditors alike.

Clarke Bell can help you

If you have used the corporate insolvency test and your company is insolvent, we can help you.

Clarke Bell have been helping company directors deal with their debt problems for more than 29 years.

If you want to discuss your situation and the options available to you, give us a call. 

Our advice is free, and will give you a clear understanding of what you should do now.