What is the difference between balance sheet and cash flow insolvency?
If your company is experiencing financial struggles, understanding whether your company is insolvent or not is one of the most crucial assessments you’ll make as a company director.
In Scotland, as throughout the UK, there are specific legal tests that determine insolvency, and the results of these tests have significant implications when it comes to your legal duties as a director and the options available for your company. Recognising insolvency at an early stage can help you take appropriate action to protect your creditors, your company, and your own position as a director.
Cash flow test v Balance sheet test
Scottish company law recognises two distinct tests for determining insolvency, both of which are derived from the Insolvency Act 1986. A company may be considered insolvent if it fails either test and understanding the difference between them is essential for making informed decisions about your company’s future.
The Cash Flow Test – This test examines whether your company can pay its debts as and when they fall due. It’s a practical, day-to-day assessment of your company’s financial position. If your company cannot meet its obligations, such as paying creditors and other debts, when payment become due, it may be considered insolvent under this test, regardless of the overall value of company assets.
The Balance Sheet Test – This compares your company’s total assets against its total liabilities. If liabilities exceed assets, taking into account contingent and prospective liabilities, your company may be insolvent under this test. This assessment requires a more comprehensive evaluation of your company’s financial position, including future obligations and any potential claims.
Understanding the cash flow test for insolvency
The cash flow test is often the more immediate concern for struggling companies, and pressure on cash flow is typically the first warning sign a company director will get that all is not well within the business. The cash flow test focuses on immediate liquidity rather than overall financial strength. Key indicators that your company might fail this test include:
- Inability to pay suppliers
- Bounced cheques or failed direct debits
- Increasing pressure from creditors with demands for payment that cannot be met
- Having to ask for extended payment terms with creditors.
The cash flow test also considers whether your company can reasonably expect to be able to pay debts as they fall due in the immediate future, not just current obligations.
Temporary cash flow difficulties does not necessarily mean that the company is insolvent. The sooner action is taken when financial performance dips, the greater the chance of turning the situation around is.
Understanding the balance sheet test for insolvency
The balance sheet test provides a broader look at the company’s state by examining its overall financial position. This test can be more complex to apply because it requires a careful valuation of assets and a comprehensive assessment of all liabilities.
When applying this test, you must consider not just current liabilities but also contingent liabilities (such as guarantees that might be called upon) and prospective liabilities (future obligations that can be reasonably anticipated). Asset valuation should reflect realistic market values rather than book values.
Professional advice is often essential when applying the balance sheet test, as it requires expertise in asset valuation and liability assessment. An insolvency practitioner can help you make accurate assessments of your company’s position under this test.
What happens if my company is insolvent?
Once your company becomes insolvent under either test, your duties as a director change significantly. You have a legal obligation to consider the interests of creditors rather than just shareholders. Continuing to trade while knowingly insolvent can be seen as wrongful trading, which can result in directors incurring personal liability for company debts.
Insolvency doesn’t automatically mean you must cease trading immediately. If you have reasonable grounds to believe that continuing to trade will save the company from insolvent liquidation – perhaps through a rescue plan, new investment, or successful debt restructuring – continued trading may be justified, however, this course of action can only be decided upon by a licensed insolvency practitioner.
What are my options if my company is insolvent?
If either the balance sheet test or the cash flow test indicated that your company may be insolvent, this does not necessarily mean liquidation is the only option. Several options may be available depending on your company’s specific circumstances:
- Formal rescue procedures – These include Administration and Company Voluntary Arrangements (CVAs) which may allow your company to continue trading while addressing its financial difficulties. These formal insolvency procedures require the input of a licensed insolvency practitioner but can preserve jobs and value for creditors.
- Voluntary insolvent liquidation – This is done through a process known as a Creditors’ Voluntary Liquidation (CVL) which allow directors to take control of the wind-down process rather than waiting for creditors to force it into compulsory liquidation. A Creditors’ Voluntary Liquidation provides an orderly conclusion while demonstrating that directors are taking responsibility for the situation.
- Informal arrangements – This involves entering into negotiations with creditors to arrange a more affordable and sustainable way of repaying the money you owe. Any agreement of this kind will require creditor cooperation and will not provide the legal protections of formal procedures.
How Scotland Liquidators can help
If you believe your company could be at risk of becoming insolvent – or if you think it already is insolvent – seeking professional advice from a licensed insolvency practitioner should be a priority.
At Scotland Liquidators, we have a network of insolvency practitioners working across Scotland here to provide you and your company with the expert help and advice you need at this time. Contact a member of our team today and take the first step.
