What is the Insolvency Test for a Limited Company?

The first warning sign of corporate insolvency is typically poor cash flow, so if a company is unable to pay its bills day-to-day, it may already have entered ‘cash flow insolvency.’ There are other types of insolvency, however, with a specific test for each one.

If the company’s balance sheet shows that the value of its long-term liabilities exceeds that of its assets, it could be ‘balance sheet insolvent.’ This can occur in isolation, or alongside cash flow insolvency.

A third warning sign of potential insolvency is unresolved litigation. So how do you formally test for these different types of insolvency, and why is it important to do so?

Why test for corporate insolvency?

When a company becomes insolvent the directors’ legal obligations change and they must act in their creditors’ interests, rather than those of the company. If directors fail to prioritise their creditors – for example, by continuing to trade – they face serious sanctions and potentially personal liability for some of the company’s debts.

Investigations take place to establish the reasons why the company declined, and a report is sent to the Secretary of State. This is why, if you’re unsure whether your company has fallen into insolvency, it’s important to obtain a professional view.

The following three tests will be undertaken:

Cash flow test

The cash flow test looks at whether the company can pay its bills ‘in the reasonably near future.’ Payment times differ according to industry, but the cash flow test provides a clearer view of the situation and allows you to prioritise your creditors if necessary.

Poor cash flow is a clear sign of business distress, so if you’re finding it difficult to pay the wages, for instance, your suppliers, or any other day-to-day liability, it’s advisable to seek a professional perspective on the company’s financial position.

Balance sheet test

The balance sheet test identifies whether the company’s long-term liabilities are greater in value than its assets. If so, the company could be insolvent. When carrying out this test it’s important not to overstate or understate the figures, as this can misrepresent the company’s true position.

Examples of this include treating a long-term debt as an asset when it should be written off, or failing to include a contingent liability. Contingent liabilities are those that could materialise in the future, perhaps from current claims against the company.

Failing to provide an accurate picture of the company’s position during this test can lead to allegations of misconduct in the future.

Legal test for insolvency

Legal action taken against the company, such as a County Court Judgment (CCJ), statutory demand for payment, or winding-up petition, is a clear sign that the business is in difficulty and a strong sign of insolvency.

What to do if your company is insolvent

You must cease trading straight away and seek assistance from a licensed insolvency practitioner (IP). Prioritising creditor interests is paramount, and in doing this you protect yourself from misconduct accusations.

It may be possible to rescue or restructure the company and enable it to carry on, and the IP will assess the best way forward. If liquidation is the only option, you can instigate the process as a director and ensure you meet your legal obligations.

Creditors’ Voluntary Liquidation (CVL) protects creditors from further losses, and you may be eligible to claim director redundancy pay. UK Liquidators can undertake the insolvency tests for your limited company, and provide the professional advice you need.

We have more than 25 years’ of helping directors to voluntarily close down their companies, and operate an extensive network of offices throughout the UK. Please get in touch with our expert team to find out more.