What is insolvency, and how does a director recognise it?

office teamCaroline Clark outlines reliable indicators of financial distress, and what directors should do next.

There have been a number of high-profile insolvencies in the last year or so, many involving high street retail organisations. As much as insolvency has always been part of commercial life, it seems to be increasingly affecting retail businesses and shops that are familiar to us all.

But how do company directors know if their company is insolvent, and if they recognise the warning signs, what should they do?

The definition of insolvency

'Insolvent' is not defined in the Insolvency Act 1986 (IA1986). The phrase 'inability to pay debts' is used instead, and this is defined in S123 IA1986 as a statutory demand for a debt in excess of £750 remaining unpaid more than three weeks after service, execution on a judgement debt remaining unsatisfied in whole or part or if it is proved to the satisfaction of the court that the company is unable to pay its debts as they fall due.

S123 IA1986 goes on to advise that a company is also deemed unable to pay its debts as they fall due if the value of the company's assets is less than the amount of its liabilities, taking into account contingent and prospective liabilities.

S123 IA1986 refers specifically to compulsory liquidations, where the court makes the final decision of whether a winding up order should be made. The definition of 'inability to pay debts' is vital to give guidance to the court. The definitions of S123 IA1986 are also used by insolvency practitioners when advising about creditors' voluntary liquidations.

The legislation is very carefully written for a complex situation, and there is case law to match. Insolvency practitioners, when studying for the professional qualification that gives them the unique authority to advise on insolvency and corporate recovery, learn that audited accounts, however recent, are not a reliable indicator of solvency or insolvency. When considering whether a company is insolvent, the estimated to realise value of assets under different situations should be considered as well as cashflow, including, for example, the timing of payments to HMRC.

Spotting the signs and acting on them

Directors of well-managed companies should rely on accurate and up-to-date management accounts, produced monthly or quarterly, to assess whether or not their company is approaching financial difficulties. Management accounts are likely to include details of turnover and costs in the year to date, together with information about work in progress, debtors and creditors, and cash flow projections.

A recent example of a high street company in severe financial difficulties was only discovered by the board after HMRC presented a winding up petition. Though this situation included fraud and a £10 million overdraft that nobody, including the auditors, was aware of, the directors must be asking themselves why the company did not have controls in place to ensure that this situation was discovered earlier.

If directors realise that their company is facing financial difficulties, they should immediately seek professional advice from an insolvency practitioner. If professional advice is sought promptly, it may be possible to avoid formal insolvency, and there will be more options available for the company and its directors.

In the event that formal insolvency can’t be avoided, the insolvency practitioner appointed will investigate the directors, and how they managed the company. A critical report on the directors under the Company Directors' Disqualification Act 1986 could result in directors from being disqualified from acting as such.

All insolvency practitioners are very familiar with meeting with directors of companies with insurmountable financial problems. These problems may have been growing for some time if the company has high costs and an unsuccessful product, or may have happened very suddenly if the loss of a major client or customer has resulted in cash flow problems.

The sooner directors recognise potential or actual financial problems and seek professional advice from an insolvency practitioner, however, the better the likely outcome for the company, its directors and creditors.

About the author

Caroline Clark is an insolvency practitioner and experienced insolvency compliance consultant. She has an MBA, and is the director of RMCSC, providing independent advice for insolvency practitioners, and is a fellow of the Insolvency Practitioners Association and Association of Business Recovery Professionals (R3).

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