How do I know if my company is insolvent?

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How do I know if my company is insolvent?

‘Legal tests for company insolvency’

As a director, you feel the company might not have enough cash coming in to pay its debts and want to test if it is really insolvent. If there is a real chance that the company will ´go broke´ (be fatally insolvent) then you need to tread carefully. It´s all about the date when you knew or ´should have known´ that the company would go under – and should have gone into voluntary administration or liquidation. Technically, the legal tests for when a company becomes insolvent are:

  1. It has insufficient cash pay its debts as and when they fall due, or
  2. When the company´s current (or short-term) liabilities exceed its current assets, or
  3. When its net assets are negative. There many ways to be insolvent and inadvertently engage in insolvent trading and for a director to put his personal assets on the line. The best test is when cash or access to cash doesn’t cover debts as they are payable.

There many ways to be insolvent and inadvertently engage in insolvent trading and for a director to put his personal assets on the line. The best test is when cash or access to cash doesn’t cover debts as they are payable.

Rebuild Now Solution -v- Liquidator or Accountant – Proving Insolvency

However, and this is what a liquidator won´t tell you and your accountant may not know, proving when a company became insolvent can be a problem to prove, not just for you but for a liquidator trying to prove the date of insolvency so he can make life difficult for directors – particularly by accusing directors of insolvent trading and going after the directors’ personal assets. Knowing this and the arguments around insolvency and insolvent trading can work to your advantage and if so, the company directors should get unbiased advice from a firm like ours.

And don´t feel alone if you are a little confused by this ‘insolvent’ – ‘not insolvent’ problem. A recent survey of 100 accountants conducted by Rebuild Now across NSW revealed that at least 90 percent of their client company directors did not understand what they were signing when they completed the annual Declaration of Solvency. (This is a form that ASIC requires and accountants include with the Annual Accounts.) They did not really know if they were solvent or not insolvent. Further, at any one time the accountants indicated that 50 per cent of their clients were technically insolvent, but not necessarily ´broke´and headed for voluntary administration or liquidation.

So, what is solvency?

The answer to the question ‘Is my company insolvent?’ is an important problem because a director can be made personally liable for debts incurred after the date of insolvency due to insolvent trading and other legal provisions if the company is liquidated. So directors need to be aware of the company’s financial position and know whether it has crossed the line from “Financial Distress” to “Insolvent” – whether it will have to enter voluntary administration or liquidation.

We have provided below a checklist of matters a director should consider to assess whether it should be obvious that the company is insolvent. The Corporations Act tells us that the overriding question a director must answer is:

Is the company able to pay all of its debts as and when they become due and payable?

Usually, the answer to this question is not easy! So we don’t want you to answer the question now. First, review the list of “Indicators of Insolvency” below.

Factors that indicate the availability of cash, or lack of it, become increasingly important if the company goes into voluntary administration or liquidation because the level of scrutiny intensifies. These are the sort of things a liquidator will look at in determining when a company became insolvent. Remember, insolvency must be distinguished from a short-term cash-flow problem.

Insolvency indicators

Insolvent indicator 1.

An inability to raise equity cash or loan capital cash. A company with insufficient cash to pay its due debts will have to raise extra cash to stay solvent. It can do so by way of refinancing, the raising of equity or the rescheduling of debts. An inability to do this within a reasonable time indicates that the problem is not simply short-term cash-flow problems and perhaps the directors should place the company into voluntary administration or liquidation and perhaps the company directors should get unbiased advice from a firm like ours.

Insolvent indicator 2.

Issuing post-dated cheques or having cheques dishonored. Issuing a postdated check is an admission that a company has insufficient funds to pay all due debts. A postdated check that is also dishonored is a clear sign that the problem is more than a cash-flow difficulty and perhaps the company should go into voluntary administration or liquidation after getting unbiased advice from a firm like ours.

Insolvent indicator 3.

Payments in rounded sums and for the minimum amount due. Debtors sometimes resort to making a small payment to a creditor, often in a round amount. This is a sign that the debtor hopes to resolve the situation in the near future and that the creditor will be satisfied with a series of small payments. The inference is that this small payment is being made because the debtor cannot pay all its debts as they fall due and perhaps the directors should place the company into voluntary administration or liquidation and perhaps the company directors should get unbiased advice from a firm like ours.

Insolvent indicator 4.

Overdue tax remittances. Insolvent companies regard withholding the cash payment of tax commitments as the easiest way of preserving essential cash in the short term. The inference is that any underpaid amount of tax due to the ATO is not paid because the business does not have the capacity to make the payment and perhaps the company should go into voluntary administration or liquidation after getting unbiased advice from a firm like ours. A directors penalty notice is also a red flag – call us immediately if this happens.

Financial statements should provide sufficient information for a company owner to determine the likelihood of insolvency. A lack of financial information does not necessarily indicate insolvency but is a common symptom. Remember that a lack of financial records is proof under a separate provision of the corporations law that the company is and was insolvent from the point of not having them.

Insolvent indicator 5.

Continuing losses and insufficient working capital. Making continuing losses is a red flag that should alert a director to the possibility of insolvency and perhaps the company should go into voluntary administration or liquidation. Insolvency is brought about by a combination of losses and insufficient working capital to carry the company through to a profitable period.

Insolvent indicator 6.

A lack of timely and accurate financial information. Without regular financial information, a director will not know the financial position of a company. Whilst this does not necessarily dictate that a company is insolvent, it is a very common symptom of an insolvent company.

A company’s solvency often relies on the support of other stakeholders such as creditors, employees and the bank. An indication of the financial health of a company is the state of the relationship with other key stakeholders.

Insolvent indicator 7.

Poor relationship with your bank. Banks have a privileged position with their ability to see a company’s financial transactions and cash levels. The bank is often the company’s main source of new funding and if that avenue is closed a company will have limited options.
Insolvent indicator 8. Suppliers demanding cash on delivery trading or cash before supply indicates a problem. Having your company placed on “C.O.D. Only” by a supplier indicates that the supplier has no faith in your company´s ability to pay its debts. A company that has a range of creditors with accounts outside of agreed terms is at high risk of being insolvent and perhaps the directors should place the company into voluntary administration or liquidation and perhaps the company directors should get unbiased advice from a firm like ours.

Insolvent indicator 9.

Creditors issuing demands or legal proceedings. A single demand for cash from a creditor is not proof of insolvency as the debt may be in dispute. However, a series of demands from a number of solicitors will create a strong presumption of insolvency and perhaps the company directors should get unbiased advice from a firm like ours.

We would have liked to now provide you with a simple formula based on the number of ticks you gave to the above indicators of insolvency. Unfortunately, it is not that simple.

Here’s what we can say:

  • One or two indicators – does not necessarily indicate insolvency, but you should be concerned if the indicators persist.
  • Two or three indicators – you should strongly consider the possibility that your company is insolvent and perhaps the directors should place the company into voluntary administration or liquidation and perhaps the company directors should seek unbiased advice from Rebuild Now.
  • Four or more indicators – if your company displays four or more of the above characteristics then your company is probably insolvent and perhaps the directors should place the company into voluntary administration or liquidation and perhaps the company directors should seek unbiased advice from Rebuild Now.

If you are concerned that your company is insolvent you must act now to get unbiased advice. Note, some liquidators will tell you to go into voluntary administration or liquidation immediately (more fees and jobs for them). No, no, no. Not until after getting unbiased advice from a firm like ours. Review our page on Directors Personal Liability if you need some extra impetus to focus your mind.

Remember, that if your company is insolvent (AND WILL LIKELY NOT SURVIVE) you must act to avoid personal liability to other stakeholders such as creditors and employees. However, if your company is simply in financial distress or might become fatally insolvent then you need to talk to experts who can put you in a better place, spell out your options.

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