How to test whether your company is solvent - the balance sheet test

What is Balance Sheet Insolvency? Complete guide for company directors

If your company appears to be approaching insolvency, it is not just cash flow that you should be worried about. You also need to analyse the figures on your balance sheet to be certain of your situation.

Although negative cash flow and the inability to pay creditors on time is a clear indicator of financial troubles, these may just be temporary, but a balance sheet test can provide a broader view of the problems you’re facing.

So what exactly is balance sheet insolvency, and how can you test your business?

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Balance sheet insolvency

Balance sheet insolvency occurs when a company’s total liabilities are greater than its assets – a situation that can be determined by taking a ‘balance sheet test.’ Along with a cash flow test, it provides a clear picture of the company’s financial status, and helps directors to avoid accusations of insolvent trading.

An accurate balance sheet test will include contingent and prospective liabilities, such as deferred payments or potential litigation decisions against the company, so that a precise assessment can be made.

It’s a good idea to obtain professional help when establishing solvency/insolvency. It’s very easy to arrive at a positive outcome incorrectly, and later discover that the company is in fact technically insolvent.

This can happen when assets are valued incorrectly or contingent liabilities are omitted from the calculations, and can lead to personal liability for debts incurred whilst trading insolvently.

Prior to taking the balance sheet test, however, many companies apply the cash flow test to their business.

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What is the cash flow insolvency test?

If a company cannot pay its bills as they fall due, or in the “reasonably near future,” it may be wound up under the terms of the Insolvency Act 1986. The longer the time period used in the cash flow test, however, the more hypothetical the result becomes, diluting accuracy and reducing confidence in the outcome.

So how do you define the “reasonably near future” mentioned in the Insolvency Act?

A Supreme Court ruling in 2013 stated that, in determining insolvency via the cash flow test, the term “reasonably near future” might vary according to industries, and that other commercial circumstances specific to each case should be taken into account.

It’s a feature of the construction industry, for example, that firms endure long payment terms – a factor that will be incorporated into a cash flow test if a firm is facing insolvency. Cash flow insolvency is relatively easy to account for, but what are the possible reasons for balance sheet insolvency.

Why are the company’s liabilities greater than its assets?

There are various reasons why the value of your company’s assets may have fallen below its liabilities. Directors could have withdrawn too much money over time, leading to overdrawn directors’ loan accounts that the company can no longer support.

If there were insufficient distributable profits to cover one or more dividend payments, it is also likely that the dividends would be deemed unlawful. The potential for litigation against directors in these instances, by creditors or a liquidator if the company is wound up, is high.

A common area where mistakes are made is in over-stating asset figures, particularly stock. For this reason, it’s important to ensure valuations are accurate, and that a true and fair view of the business is presented in its financial statements.

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