What is Company Insolvency?

Financial distress can happen to any business, even those that appear outwardly successful.

Understanding insolvency and its implications allows directors, creditors, shareholders and other stakeholders to navigate challenging circumstances wisely.

This guide provides an in-depth look at insolvency in the UK – what defines it, the procedures involved, how to spot warning signs and steps to minimise risks.

We’ll start by explaining what constitutes insolvency as well as common triggers like poor cash flow or excessive debts. Next, we’ll outline formal insolvency processes like administration and liquidation so you understand the proceedings.

Importantly, we’ll examine potential consequences for creditors left unpaid, directors facing disqualification, employees made redundant, and shareholders losing investments.

While daunting, insolvency does not necessarily mean shutting down.

With professional advice and careful management, some businesses can restructure and recover. Our goal is to offer accurate, accessible information so you can make informed decisions even in the most difficult situations.

What is Limited Company Insolvency?

Insolvency refers to the state of a business or individual when their liabilities exceed their assets, making them unable to repay debts.

There are two main tests for insolvency:

• The cash flow test – Unable to pay debts as they fall due. Even if assets exceed liabilities on paper, debts cannot be paid.
• The balance sheet test – Liabilities exceed assets. Total debts are greater than total assets, meaning insolvency.

Being declared insolvent has major consequences. For companies, directors must shift focus to creditors and cease trading. Seeking professional advice and entering a formal insolvency process may be necessary.

Insolvency may result from poor financial planning, economic downturns, lawsuits, or loss of a major client or contract. Even previously successful companies can become insolvent under certain conditions.

Some common causes of insolvency include:

• Poor cash flow management
• Taking on excessive debts
• Lawsuits and legal action
• Loss of critical business contracts
• Changes in consumer demand or behaviour

Types of Insolvency

There are two main types of insolvency that businesses can face:

Cash Flow Insolvency

This occurs when a business does not have enough cash available to pay its debts and obligations as they become due, even if its assets exceed its liabilities on paper.

Cash flow insolvency is often a temporary state that can be improved by liquidating assets, restructuring debts, or obtaining new financing. However, ignoring consistent cash flow issues can lead to more severe balance sheet insolvency down the line.

Signs of cash flow insolvency include:

• Consistently late bill payments
• Dependence on credit to pay expenses
• Inability to secure new financing

Balance Sheet Insolvency

This is when the total liabilities of a business exceed its total assets. Even liquidating all assets would not yield enough funds to repay debts.

Causes include heavy operating losses over time, lawsuits, or sudden loss of a revenue stream. Balance sheet insolvency typically requires a major restructuring or bankruptcy proceeding to address.

Signs of balance sheet insolvency include:

• Total debts exceeding total asset value
• Bankruptcy seems inevitable without intervention.
• Net worth is significantly negative

What are the Causes of Insolvency?

There are various situations and factors that can cause a previously solvent business to become insolvent. Common causes include:

Poor Financial Management

• Inaccurate budgeting
• Failure to monitor cash flow
• Taking on excessive debts or liabilities
• Poor accounting practices

Business Interruptions

• Loss of major customer or contract
• Supply chain disruptions
• Natural disasters impacting operations

Lawsuits

• Customer litigation
• Patent infringement claims
• Employee discrimination suits

Industry Changes

• A decline in demand for products/services
• New competitors entering the market
• Rise of substitute products or technology

Economic Downturns

• Reduced consumer spending during recessions
• Tightening of credit markets
• Stock market declines, hurting investments.

While insolvency may not always be preventable, monitoring finances, operations, and market conditions can help minimize risks. Being aware of potential triggers can help directors take action before insolvency occurs.

What are the Consequences of Insolvency?

Becoming insolvent can have serious implications for a company as well as its creditors, directors, and employees.

Key consequences include the following:

For Creditors

• Loss of all or part of the money owed by the insolvent company
• Having to wait longer to get repaid during insolvency proceedings
• Loss of collateral/security interests during liquidation

For Directors

• Personal liability for company debts, in some cases
• Restrictions on serving as a director after insolvency, such as disqualification
• Reputational damage affecting future career

For Employees

• Job loss if operations are shut down
• Loss of wages if the company cannot pay salaries
• Disruption of benefits, insurance, and retirement plans

For Shareholders

• Sharply reduced value or total loss of their investment
• Loss of voting rights in company decision making
• No equity remaining after liquidation

Insolvency creates fallout that impacts stakeholders in different ways. Being aware of these potential consequences can help inform prudent financial management.

Advice for Directors Facing Insolvency

A diagnosis of insolvency comes with immediate and significant implications for the business and its stakeholders.

1. Director’s Responsibilities Change – In insolvency, a director’s primary responsibility shifts away from shareholders and towards creditors. Every action must demonstrate this is understood.
2. You should cease trading – A company that is insolvent must cease trading or risk accusations or ‘wrongful trading’ further down the line.
3. You should seek professional advice: It is important for company directors and shareholders to seek professional advice from an insolvency practitioner or other qualified advisor as soon as possible. This can help assess the insolvency’s severity and identify potential options for addressing the situation.
4. You may need to enter a formal insolvency process: In some cases, a formal insolvency process, such as administration or voluntary arrangement, may be necessary to protect the company from legal action and provide a framework for restructuring or winding down the business.

Ultimately, the key to managing insolvency for a company is to take proactive steps to address the situation as soon as possible. This may involve seeking professional advice, engaging with creditors, and exploring all available options for restructuring or winding down the business.

What are the Main Insolvency Procedures?

In the UK, several main corporate insolvency proceedings can be used to address a company’s financial difficulties. Their processes differ for each one.

These include:

1. Liquidation (also known as winding up): This is the process of bringing a company’s existence to an end and distributing its assets to creditors. There are two types of liquidation: compulsory liquidation (ordered by the court) and voluntary liquidation (at the company’s or its shareholders’ request).
2. Company voluntary arrangement (CVA): This is a legally binding agreement between a company and its creditors to pay all, or a proportion of, its debts over an agreed period. An insolvency practitioner supervises the process.
3. Administration: This is a process in which an administrator is appointed to manage the company’s affairs, business, and property with the goal of rescuing the company as a going concern or achieving a better outcome for the company’s creditors as a whole than would be likely if the company were immediately wound up.

What are the Main Insolvency Laws in the UK?

Insolvency Laws and Regulations

In the UK, the main laws that cover corporate insolvency processes include:

• The Insolvency Act 1986 – Primary legislation defining insolvency tests and proceedings.
• The Insolvency Rules 1986 – Details procedures for liquidations, administrations, and voluntary arrangements.
• The Insolvency Regulations 1994 – Covers the conduct of insolvency practitioners.
• The Insolvency Act 2000 – Amended the 1986 Act, including on directors’ duties.
• Company Directors Disqualification Act 1986 – Outlines director conduct standards.
• Employment Rights Act 1996 – Covers employee rights in insolvency.

Key requirements under these laws include:

• Directors must properly manage creditor interests once insolvent.
• Insolvency practitioners must be qualified and licensed.
• Creditors must be informed and approve major decisions.
• Assets are distributed in order of priority class.
• Directors can be personally liable for wrongful trading.

Understanding the legal framework for insolvency is important for directors navigating the process and achieving the best outcomes possible. Seeking qualified professional advice can help ensure full legal compliance.

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If you need help understanding the best way forward for your company, use the live chat during working hours, or call us on 0800 074 6757. We’ve helped 1000’s of directors navigate difficult financial circumstances.

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