What is the Insolvency Test for a UK Limited Company?
If you’re struggling with financial difficulties, you may have heard the term “insolvency” thrown around. But what does it mean to be insolvent, and how can you know if you’re in that situation?
The answer lies in the insolvency test, a legal and financial assessment used to determine whether a person or company is unable to pay their debts.
In this article, we’ll take a closer look at the insolvency test and how it works. You can also use our free interactive tool that will tell your status in just 30 seconds, without obligation.
What is the Insolvency Test?
The insolvency test is a legal and financial assessment used to determine whether a limited company is unable to pay their debts as they become due, or if their liabilities exceed their assets.
The most common way of checking whether your business is insolvent is by using one or more of the methods detailed below.
We always also recommend speaking with an experienced insolvency professional. This is a service we provide free of charge so please do get in contact.
The 3 checks that the insolvency test covers are as follows:
- The cash-flow test.
- The balance sheet test.
- The legal action test.
Cash-flow Insolvency Test
The cash-flow test is designed to find out whether a business can pay its bills when they fall due.
This test isn’t simply about can you pay your bills at this exact moment, either. The legal requirement is that you are able to pay your bills in the ‘in the reasonably near future.’
What Qualifies as Insolvency? – If your business cannot pay its bills on time, the chances are that it is mostly likely insolvent.
Example – ABC Ltd is a manufacturing company that has been operating for several years. They have been struggling to generate enough revenue to cover their operating costs, and as a result, they have been relying on their line of credit to cover their expenses. They owe £500,000 to their suppliers, and they have £400,000 in assets.
Their accountant has performed a cash flow analysis and determined that the company is cash flow insolvent. Specifically, the analysis shows that the company’s liabilities exceed their assets, and they are unable to pay their debts as they become due.
Balance Sheet Insolvency Test
This part of the test aims to determine whether the value of the business’ cash at the bank, as well as the total value of assets combined, are more or less in value than the total value of liabilities that the business has.
The balance sheet test is one you will ideally look at in conjunction with your accountant as these figures must be accurately and clearly represented.
What qualifies as insolvency? – If the total value of assets and cash combined has a value that is less than the total value of liabilities under the business name, chances are, it is insolvent.
Example – XYZ Ltd is a retail company that has been experiencing financial difficulties due to decreasing sales and increased competition. They have £1 million in liabilities, including outstanding loans and unpaid bills, and only £800,000 in assets, including inventory and equipment.
Their accountant has performed a balance sheet analysis and determined that the company is balance sheet insolvent. Specifically, the analysis shows that the company’s liabilities exceed their assets, which means that they do not have enough assets to cover their debts.
The Legal Action Insolvency Test
The final part of the test aims to highlight whether any legal action has been taken out against the business for any debt to the value of £750 or more.
This refers specifically to Statutory Demands, or County Court Judgements, both of which are the classic precedents to a winding-up procedure.
What qualifies as insolvency? – If your business has had legal action set against it of this value of the debt or greater, your business may be insolvent.
Example – LMN Ltd is a construction company that has been facing financial difficulties due to cost overruns on several projects. They owe £500,000 to a supplier who has issued a statutory demand for payment. The company has been unable to pay the supplier and has not reached a payment agreement with them.
In this case, the legal action insolvency test would apply. If a company fails to pay a statutory demand within 21 days, it is presumed to be insolvent under UK law. This means that the supplier could potentially apply to wind up LMN Ltd in court.
Check if Your Company is Insolvent
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Or for more information on what to do if your business is insolvent contact us on 0800 074 6757, or you can email us at firstname.lastname@example.org or use the live chat feature.