In simple terms being insolvent means you do not have sufficient assets to pay your debts.
However, if the inability to pay debts is genuinely just a short term issue, your business may not be insolvent in the legal sense that you need to stop trading.
The legal test for insolvency means making an honest assessment of whether you are genuinely likely to be able to improve your business financial position so as to be fair to creditors, taking into account current trading and medium and long term debts as well.
If your business is insolvent, you need to take action which reflects this. Continuing to trade when insolvent, juggling debts or favouring some creditors over others is unlawful and will create risks of personal liability for directors. If you’re unsure of your situation, consider using our insolvency test. Or speak with one of our insolvency practitioners.
What is Company Insolvency?
Under UK law, insolvency can be defined as when debts outweigh assets or if bills cannot be paid when due.
Insolvent companies are responsible to creditors interests primarily, rather than shareholders.
A creditor (someone you owe money to) only needs to be owed £750+ to be able to force your company into liquidation by the use of a winding up petition if you are insolvent.
The definition of the inability to pay business debts is laid out in the Insolvency Act 1986, Section 123.
Understanding Company Insolvency
The insolvency process for companies will often depend on who takes the initiative. The company may commence a creditors voluntary liquidation or consider going into administration. If the company directors do not act, the creditors themselves may commence a compulsory liquidation process.
By closing the company via a process such as liquidation, all of the debt can be eradicated and the company closed.
Before this, directors should first ascertain the company’s position via the corporate insolvency test.
These tests are used by accountants to check, via 2 methods, whether a company is officially insolvent. If you fail either, you should speak with an insolvency practitioner immediately.
What if I’m not sure Whether my Business is Insolvent or Not?
Many businesses experience cash flow problems but if your business has ongoing problems paying creditors and you are delaying paying some suppliers and/or have falling revenues, you will probably realise yourself that the business is insolvent or very close to it. If you are behind in paying HMRC this is a major warning sign of being insolvent.
There is no single, definitive legal or accounting test for insolvency. In many cases, the answer is obvious but complications can arise where a business may be able to pay very short term debts but realistically cannot pay loans, rent, taxes or other debts which are payable in the next 3-6 months.. There are 2 tests which will generally assist detailed below. If in doubt as to whether your business may be insolvent, the best thing to do is get professional advice early to protect yourself.
(1) The Balance- Sheet Test
Do your company’s debts outweigh its assets?
That’s the essential question posed by the balance sheet test. Simply list down all of your company’s assets in one column, and the contingent and prospective liabilities in another. If the value of the assets is lower than the liabilities, you are facing balance sheet insolvency (also called technical insolvency)
(2) The Cash-flow Test
Can your company pay its bills on time? That’s the simple question posed by the cash flow insolvency test.
This test looks at the amount of working capital or liquid assets you have available at any given time, comparing forecasted sales with payments that are due.
If you’d rather use a simple tool that does both these things, you easily complete that process here .
What Happens When Your Business is Insolvent?
If your business is insolvent you will need to stop trading. Continuing to trade after you know or ought to know your business is insolvent is, in legal terms, wrongful trading and means you may face personal liability for company debts.
For directors, speaking with an IP will help you understand your options, how to protect yourself from insolvent trading , accusations of wrongful trading and potentially being made personally liable for any company debts.
The goal of any insolvency is to realise the maximum return for the company’s creditors. To this end, the appointed insolvency practitioner’s (IP) have a number of tools and processes at their disposal which we explain later in this article.
If you’re concerned you won’t be able to afford the IP, you should be aware that most liquidations can be paid for from the realisation of corporate assets. Directors may also be eligible for redundancy payments.
What are Insolvency Proceedings?
Insolvency Proceedings is the collective term for legal mechanisms whether winding up, liquidation, company administration, receivership and, for individuals, bankruptcy.
What are the Main Insolvency Laws?
The key UK insolvency laws are:
- The Insolvency Act 1986
- The Insolvency Rules 1986
- The Company Directors Disqualification Act 1986
- The Employment Rights Act 1996 Part XII, the Insolvency Regulation (EC) 1346/2000.