Being able to determine if your company is insolvent or not is essential since a director can end up facing a lot of serious consequences if the company incurs debt or debts after it become insolvent. These can include compensation proceedings, criminal charges, and civil penalties. But, it is usually hard to identify if a company already crossed that significant line of having a problem with cash flow to and going down the road to bankruptcy.
This article takes a look at insolvency indicators and legal tests that companies can use to know if they are facing financial difficulties in the horizon.
Legal Tests to Determine Company Insolvency
The section 95A of Corporations Act 2001 defines insolvency as follows:
- A person is only solvent if the person can pay all of his or her debts when and as they become payable and due.
- A not solvent person is insolvent.
It is not straight forward to answer the question if a company can pay all its debts when and as they become payable and due. The Courts took into consideration section 95A’s operation and listed down several insolvency indicators.
Insolvency Indicators
Potential indicators of insolvency include the following:
- Liquidity ratio less than 1 – Liquidity ratio is determined through dividing total liquid assets by short term borrowing amount. This will show if short term liabilities have been covered.
- Continuing losses – Company insolvency stems from the combination inadequate working capital and losses. Incurring continuing losses is a serious red flag for a company director indicating the likelihood of insolvency.
- Lack of access to alternative finance – Companies with inadequate cash for paying its debt have to raise additional money to remain solvent. The lack of ability to refinance with banks or increase equity shows absence of confidence in the viability of the company.
- Payment of rounded sums to creditors – It indicates that the company makes payments based on available cash at the time and the company lacks the ability to pay off its debt.
- Issuing dishonored or post-dated cheques – It shows that the company is unable to pay its due debts.
- Overdue remittances of taxes – Withholding the payment of tax commitments is usually considered as the easiest means for companies to preserve their cash flow in short term. This is a strategy being adopted by most companies facing financial strife.
- Lack of accurate and timely financial information – The ability of a business to maintain organized and accurate records are a great sign of its wellbeing.
- Suppliers place debtor on COD or cash on delivery terms – This is an evidence that there is a deterioration in the trading relationship of the company with its suppliers.
- Poor relationship with the bank – Banks can see the cash levels and financial transactions of a company. This is why they are the first ones that can assess a company’s financial position. If a bank cannot extend additional credit, this shows that the bank doesn’t see the company as financially sustainable.
- Creditors issue legal proceedings or demands – Legal proceedings or demands are serious concerns since these pave way to involuntary liquidation and requires close monitoring.