What is the Insolvency Test for a Limited Company?

When directors of a limited company face financial difficulties, the tipping point to insolvency represents an important threshold, after which responsibilities change.

As such, it’s vital that the company’s insolvency status is clearly understood and, to achieve this, there are several tests which can be conducted.

These tests determine whether the company is unable to pay its debts as they fall due (cash flow insolvency) or if its liabilities exceed the value of its assets (balance sheet insolvency).

If a company is found to be insolvent based on the tests, the directors must take steps to protect creditors’ interests, which may involve initiating formal insolvency proceedings.

30 Second Test

How to Test for Insolvency

The 3 checks that the insolvency test covers are as follows:

  1. The cash-flow test.
  2. The balance sheet test.
  3. The legal action test.

Cash-flow Insolvency Test

The cash-flow insolvency test assesses if a business can pay its bills on time, both now and in the near future. It’s not just about having enough cash at this moment but ensuring the company can continue to meet its debts as they come due.

If your business cannot pay its bills on time, it is most likely insolvent.

To perform a cash-flow insolvency test, you need to:

  1. Forecast Cash Flow: Estimate future cash inflows and outflows for a near-term period.
  2. Assess Liquidity: Check if the business has enough cash to cover its short-term liabilities.
  3. Evaluate Solvency: Determine if the business can pay its bills as they come due in the near future.

Example—ABC Ltd is a manufacturing company that has been operating for several years. It has been struggling to generate enough revenue to cover its operating costs, so it has been relying on its line of credit to cover its expenses. It owes £500,000 to its suppliers and has £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 its assets, and it is unable to pay its debts as they become due.

Balance Sheet Insolvency Test

The Balance Sheet Insolvency Test involves comparing the total value of a business’s assets (including cash) to its liabilities. If the assets are less than the liabilities, the business is likely insolvent. This test requires accurate financial records and often involves working with an accountant to ensure all values are correctly represented.

Example—XYZ Ltd is a retail company experiencing financial difficulties due to decreasing sales and increased competition. It has £1 million in liabilities, including outstanding loans and unpaid bills, and only £800,000 in assets, including inventory and equipment.

Their accountant performed a balance sheet analysis and determined that the company was insolvent on the balance sheet. Specifically, the analysis shows that the company’s liabilities exceed its assets, which means that they do not have enough assets to cover its debts.

The Legal Action Insolvency Test

The Legal Action Insolvency Test examines whether a company faces legal challenges due to unpaid debts, specifically through Statutory Demands or court judgments like County Court Judgments (CCJs).

A failure to settle a debt over £750 may lead to the company being wound up.

This situation suggests the company cannot meet its financial obligations, raising serious concerns for insolvency.

The test is a critical signal for the company to consider stopping trading and prioritising creditor interests. It is recommended that immediate consultation with a licensed insolvency practitioner be undertaken.

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. Under UK law, a company is presumed to be insolvent if it fails to pay a statutory demand within 21 days. This means that the supplier could potentially apply to wind up LMN Ltd in court.

What Options are Available?

If your business is facing financial difficulties, it’s crucial to explore all available options to address debt and avoid insolvency. Taking early action can make a significant difference in the outcome for your company.

  • Seek Professional Advice: Contact a licensed insolvency practitioner (IP) to discuss your situation. We can offer expert guidance on the best course of action tailored to your company’s specific circumstances.
  • Company Voluntary Arrangement (CVA): This is an agreement with your creditors to pay debts over time. CVAs can offer a flexible way to repay while continuing your business operations.
  • Administration: This option provides protection from creditors while a plan is developed to pay debts, sell assets, or find a suitable way to rescue the business.
  • Liquidation: If your business cannot be saved, liquidation involves selling assets to pay off debts before closing the company. This is often seen as a last resort.

For more information on what to do if your business is insolvent, contact us at 0800 074 6757, or you can email us at info@companydebt.com or use the live chat feature