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 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?
So what does it mean to be insolvent?
Insolvency is a state of financial stress relating to persons or businesses who cannot pay their debts.
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 test for insolvency which gives a certain answer as to whether your business is insolvent in legal terms. There are 2 tests which will generally assist detailed below. If in doubt, 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 accurately maps the amount of working capital or liquid assets you have available at any given time, comparing forecasted sales with payments that are due.
Since cash-flow insolvency is caused by a lack of liquidity, it can often be resolved by negotiation or payment by intalments.
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?
Being insolvent doesn’t necessarily mean the end of your company, there are options for business debt restructuring, company rescue and business turnaround. Insolvency practitioners, if brought in at an early stage, will almost certainly consider whether the business could be made solvent again rather than simply liquidating it.
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.
Examples of Business Insolvency
David forms a limited company which does well for several years before the COVID-19 pandemic stops his cash-flow overnight and debts accrue.
Tied into a costly office lease, David’s company has five full time employees who he cannot pay.
After working with his accountant to check that the company is officially insolvent, David contacts an insolvency practitioner who investigates how much money is owed; whether David has signed personal guarantees for finance, and whether the business is likely to return to profitability in the future.
Concluding that the company needs to be closed, the insolvency practitioner places the company into liquidation, and takes over creditor communication.
David assists the IP with the creation of a Statement of Affairs document, detailing the company’s financial affairs, after which his powers as a director cease.
After a year, the liquidation process is complete, the company is removed from the Register at Companies House and ceases to exist.
How does Insolvency Affect Company Directors?
As the director of a limited company you should understand how insolvency proceedings are going to affect you. Some processes are there to keep the company afloat so that it may live another day.
If the company is liquidated, your company will be closed, and struck off the register at Companies House. Any assets will be liquidated to pay off creditors.
As a director you will be free to become the director of another company and, assuming there’s no wrongful trading or misfeasance, the closure should not impact your personal finances.
What are Insolvency Proceedings?
Insolvency Proceedings is the collective term for legal mechanisms whether winding up, liquidation, company administration, receivership and, for individuals, bankruptcy.
An insolvency practitioner (IP) is someone who is authorised to act on behalf of insolvent companies, or individuals.
It should be emphasised that IP’s are not simply figures who liquidate companies, but who will always seek to rescue the company if that is a viable proposition.
While the task is always to find the best deal possible for any company creditors, it may well be that processes such as administration, or a company voluntary arrangement, offer the best chance of doing so.
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.