What is Balance Sheet Insolvency? A complete guide for company directors
Suppose your company seems to be nearing insolvency. In that case, it’s crucial not only to focus on cash flow but also to scrutinise the numbers on your balance sheet for a clear understanding of your situation.
While negative cash flow and delays in paying creditors signal financial difficulties, these issues might be temporary. Conducting a balance sheet assessment offers a comprehensive insight into the challenges you’re encountering.
So, what precisely is balance sheet insolvency, and how can you assess your business?
When does the Balance sheet insolvency occur?
Balance sheet insolvency arises when a company’s total liabilities surpass its assets—a condition identified through a ‘balance sheet test.’ This, coupled with a cash flow assessment, offers a comprehensive view of the company’s financial health and aids directors in avoiding allegations of insolvent trading.
An accurate balance sheet evaluation considers contingent and potential liabilities, such as deferred payments or impending legal actions against the company, ensuring an exact assessment.
Seeking professional assistance when determining solvency/insolvency is advisable. Incorrectly concluding a positive outcome may result in later discovery of technical insolvency. Errors in asset valuation or overlooking contingent liabilities in calculations can lead to personal liability for debts incurred during insolvent trading.
Before conducting the balance sheet test, many companies first apply the cash flow evaluation to their operations.
What is the cash flow insolvency test?
If a company fails to meet its financial obligations promptly, or within the “reasonably near future,” it may face winding up under the provisions of the Insolvency Act 1986. However, using an extended timeframe in the cash flow assessment can lead to more speculative results, diminishing accuracy and confidence in the outcome.
So, what exactly constitutes the “reasonably near future” mentioned in the Insolvency Act?
A Supreme Court ruling in 2013 highlighted that defining insolvency via the cash flow test requires considering the term “reasonably near future” in light of industry norms and the specific commercial circumstances of each case.
For instance, the construction industry often grapples with lengthy payment terms, a factor taken into account in a cash flow test during insolvency assessments.
While cash flow insolvency is relatively straightforward to identify, what are the potential causes of balance sheet insolvency?
What factors contribute to the company having more liabilities than assets?
Various factors could contribute to your company’s assets falling below its liabilities. Directors may have withdrawn excessive funds over time, resulting in overdrawn directors’ loan accounts that the company cannot sustain.
If there were insufficient distributable profits to cover one or more dividend payments, these dividends might be considered unlawful. This increases the likelihood of litigation against directors by creditors or a liquidator in the event of the company being wound up.
Another common area where errors occur is in overstating asset figures, particularly stock. It’s crucial to ensure that valuations are precise and that the financial statements present a true and fair view of the business.
Vanguard Insolvency offers director advice online, over the phone, or in person at any of our 100 UK offices or a location convenient for you.
Read More:
I am an insolvency professional with a distinguished career specialising in commercial insolvency, adeptly navigating Creditors Voluntary Liquidation, Company Voluntary Arrangements, and Company Administrations. With a comprehensive understanding of insolvency laws and an unwavering commitment to ethical practices.