How can I recognise when my business has become insolvent?

The key indicators to be aware of, and what to do next.

Despite the uncertainty surrounding Brexit, the UK so far continues to attract investment, with GDP continuing to grow (at a rate of 0.5 per cent).

However, although the economy is still expanding overall, sectors that are always volatile, such as construction, are seeing a slight contraction. This means that insolvency may become of greater significance in the months to come, as the impact of Brexit becomes clearer.

Insolvency is a legal term that recognises when a business has insufficient assets to cover its debts and is unable to pay these debts when they fall due. The laws and rules governing how the insolvency is carried out are contained under the Insolvency Act 1986 ('IA'), updated by the Enterprise Act 2002

The Insolvency Rules 2016 were laid before parliament in October 2016 and will come into force on 6 April 2017, replacing the Insolvency Rules 1986. The amendments have been reincorporated to make the process of insolvency more efficient and consequently, reduce the regulatory burdens on insolvency practitioners.

So how can I tell if my business is insolvent? Well, there are two key indicators that can be used to identify this:

  • the cash flow test (s 123(1)(e))
  • the balance sheet test (s 123(2)) 

Cash flow test

This is one of the most elementary tests that a company can carry out. One of the key questions to ask is: can the company pay its debts when they fall due? An inability to pay suppliers on time, and often requesting longer credit periods, may well be a sign that the business is insolvent.

Alternatively, the lack of payment by debtors can be another indication of future problems and indicate that debtors are in financial trouble. This could have a domino effect on your company. An additional indicator is the failure to meet the payroll, or the bank refusing to expand a business overdraft facility. 

Balance sheet test

The balance sheet test considers the assets and liabilities of a company. If, for example, the asset value is less than its liabilities, taking into account its contingent and prospective liabilities, then it may be possible to prove to court that the company is insolvent under the IA 1986.

However, this test in practice is rarely used, because it is often difficult for the creditors to obtain the information, and in turn, the company can raise the point that the figures are not up to date and therefore there should be a re-valuation of long-term assets.

Assuming that you find yourself in position in which your business has insufficient assets to cover its liabilities, it would be best to seek financial advice, as presenting a solvent picture will not exclude directors from wrongful trading, and any director could face disqualification up to 15 years. It is therefore prudent for a director of the company to present up-to-date accounts that reflects a fair and accurate view of the company’s financial position.

The decision by the Supreme Court in BNY Corporate Trustee Services Ltd v Eurosail and others [2013] provided clarity regarding the balance sheet test. The Supreme Court confirmed that the balance sheet test under 123(2) IA is far from a calculation exercise of simply adding a company’s assets against the liabilities. Rather, a mix of factors must be weighed up to consider whether a company’s present assets will enable such future liabilities to be met. The decision in this case highlights the freedom that the court will give to a company when questioning prospective future liabilities and assets.

Legal action

In addition to the above two tests, if a company finds it owes any creditor more than £750 and the creditor has consequently applied to the court to wind up a company because of unpaid debt, or is able to prove that a company cannot pay, failing to settle the debt could leave the court no choice but to make a winding up order. It generally takes 28 days for winding up order to be enforced.

If the above reflects your situation, it is essential that you seek legal advice as soon as is practical in order to minimise the damage to both your own positions as directors and, equally, as employees, so that the best possible outcome for all can be negotiated. 

Available options if your company is insolvent

The directors of a company should act as soon as possible and seek legal advice before one or more creditors serve a statutory demand. There are various options available to an insolvent company that include: appointing an administrator, refinancing and restructuring, or perhaps pre-pack administration.

Insolvency does not necessarily mean the end of the road for a business. But it would be sensible to gain professional support through the process, so you can select the option that is right for you and your company.

About the author

Savhan Lyall is part of the commercial litigation team at Wright Hassall LLP.