What Is Balance Sheet Insolvency?

August 12, 2022 / Business Insolvency

Insolvency is mainly used to refer to a company that cannot pay its liabilities when they are due. This is known as technical insolvency, and while it’s often the most appropriate term, it isn’t the only type of insolvency company directors should know.

In addition to technical insolvency, there are two other types – balance sheet insolvency and cash flow insolvency. Both act essentially as tests for insolvency, allowing directors to see how financially stable their companies are. This is essential for companies in financial distress, where directors must act in the interests of creditors. Identifying that your company is insolvent and acting accordingly will offer some protection in the event you are accused of misconduct. As such, they are terms that every director should know well.

In this article, Clarke Bell will guide you through these two lesser-known types of insolvency, detailing what they are, and how they can be used to judge your company’s finances.

What is balance sheet insolvency?

Balance sheet insolvency refers to companies that cannot pay their liabilities if they were due immediately, but may be able to once the agreed upon due date is reached. Essentially, this shows that insolvency is on the horizon, unless the company in question can raise the required capital in time. In short, a balance sheet insolvency test can be conducted to show whether your company’s liabilities exceed its assets, but leave plenty of time for action.

Testing for balance sheet insolvency

To determine whether your company is approaching insolvency, you can conduct a balance sheet insolvency test. This is a legal process, conducted by a court to determine the assets and liabilities of a company. Liabilities include the usual operational expenses, deferred payments, and other costs. This ensures that the estimate arrived at by the court is exact, offering a true reflection of the company’s finances.

Once the process is complete, there will be one of two outcomes. If the company is found to have enough assets to cover its liabilities once they are due, it will not be considered balance sheet insolvent.

If a company’s assets are found to be insufficient, it will be considered balance sheet insolvent. Having initiated the balance sheet test, you could choose to begin insolvency proceedings, or simply bear it in mind and attempt to stabilise your company’s finances. After all, a balance sheet insolvency test is meant to provide directors with a precise assessment of their company’s financial situation, rather than compel further action. However, it can be different if a creditor initiated the process and your company is found to be balance sheet insolvent. This could be taken as evidence that your company will not be able to pay its debts. In this event, your company may be forced into insolvency proceedings in order to pay back your creditors.

What is cash flow insolvency?

Where balance sheet insolvency refers to a potentially preventable state of insolvency on the horizon, cash flow insolvency refers to imminent or near-imminent insolvency. This is reflected by a company’s inability to pay its liabilities when they are due. As cash flow refers to immediate financial problems, it is not likely that the company in question can change course.

In instances of cash flow insolvency, a company is left with little choice but to enter liquidation. For asset-rich companies, they will be able to continue operations after enough capital is extracted to cover their liabilities. Companies without enough value in assets will not be able to cover their liabilities, and so will be liquidated to make repayments. In many cases, an investigation into the conduct of the directors will be opened. This is to assess whether directors have misused company funds, or otherwise engaged in wrongful trading. Directors may be held personally liable for the remaining company debts if misconduct is discovered.

Testing for cash flow insolvency

Quite like balance sheet insolvency, a test can be carried out to determine whether a company is cash flow insolvent. This will examine a company’s assets and liabilities, much like a balance sheet insolvency test, and conclude whether the company can pay back its debts. If a company is found to be unable to repay its debts, it will be considered cash flow insolvent. In this case, it can be closed in accordance with the Insolvency Act 1986.

However, unlike a balance sheet test, this is usually done to predict the near or immediate future. Cashflow tests are unreliable for long-term predictions, and so balance sheet tests are much more suitable in such cases.

What you can do if your company is insolvent

If you find that your company is insolvent due to these tests, your first course of action should be to appoint a licensed insolvency practitioner. They will offer you specialist advice, ensuring you take the best path forward and that your decision is carried out within the law.

Next, you will have to decide which outcome to pursue. For companies teetering on the edge of insolvency, but with a reasonable plan to improve profitability, continuing operations is well within reason. You should still ask your insolvency practitioner to thoroughly assess your company’s finances, as even small mistakes can have a considerable impact.

When the prospect of continuing operations is out of reach, it is likely best to consider closing your company. For insolvent companies, the best option is to pursue either a Creditors’ Voluntary Liquidation (CVL) or a Company Voluntary Arrangement (CVA). Handled by an insolvency practitioner, these forms of closing ensure that your company is closed correctly and your obligations to creditors are met. If you are considering either of these options, then speed is of the essence. You must act quickly and prevent your company’s debts from spiralling further. This will protect you from a third party petitioning for your company to be forced into compulsory liquidation, which could have consequences for you personally.

Clarke Bell can help you through

Dealing with insolvency is never a straightforward task, but we aim to make it as easy and stress-free for you as possible. Clarke Bell has over 27 years of experience in helping directors close their insolvent companies, and we can do the same for you. Contact our team today for a free, no-obligation consultation, and find out what we can do for you.