What is Insolvency?

Insolvency is a core business concept that has profound implications for those who experience it.

In this article we’ll explore what it means, how to know if you’ve reached it, and what directors should do next.

What is Insolvency?

Insolvency is a state of financial distress where either an individual or a limited company can no longer pay debts when due. Another way of defining this is where liabilities exceed assets (including cash).

When not addressed it can lead to insolvency proceedings which are legal actions designed to prompt the insolvent entity to either pay what it owes to creditors or be closed down.

While insolvency can refer to personal finances, it is more commonly used to refer to business distress in the UK, particularly limited companies or partnerships. For individuals, bankruptcy is the preferably used.

In both these cases, directors cease their responsibilities to shareholders at the point of insolvency, and assume a primary responsibility to maximise creditor returns.

How to Check if a Company is Insolvent?

A company may be considered insolvent if it fails one of these two tests:

• Cash Flow Insolvency Test – Does your company have enough cash to pay it’s bills right now? Answering no may place you in the state of insolvency.
• Balance Sheet Insolvency Test – List your assets (including cash) in one column of a spreadsheet, and your liabilities (debts) in the second. If column A is less than Column B, you are insolvent.

Examples of Insolvency

Typical examples of how a company could become insolvent include:

• cashflow problems caused by late paying customers
• loss of a key business contract which negatively affects cash flow
• shifting market forces render your key product or service less useful
• a lawsuit or other unexpected liability

What’s the Key Insolvency Legislation in the UK?

They key UK insolvency legislation for England and Wales is the Insolvency Act 1986 and The Insolvency (England and Wales) Rules 2016.

In Scotland, the correct insolvency legislation is The Insolvency (Scotland) (Company Voluntary Arrangements and Administration) Rules 2018, and The Insolvency (Scotland) (Receivership and Winding up) Rules 2018.

The main insolvency legislation for Northern Ireland is The Insolvency (Northern Ireland) Order 1989and The Insolvency (Northern Ireland) Rules 1991.

How Can We Avoid Insolvency?

It’s important to understand the warning signs of insolvency as early as possible. For the company director, the warning signs are cash flow problems, and an increasing sense of constant firefighting within the business. Perhaps key staff members leave, or a major business contract is lost. When combined with an overall lack of awareness of the company’s financial situation, including vital sales forecast documents, things can quickly spiral out of control.

This is where sound financial management, in conjunction with an accredited bookkeeper can spell the difference between success and failure. While directors may be superb at the core service of their business, it is the challenge of running a company effectively, and especially the working capital cycle, which causes many to slip into insolvency despite an overall viable business model.

How Can We Save a Business from Insolvency?

It is possible to save a business from insolvency via a process known as company rescue. Business rescue, which is a core part of the skills of an insolvency practitioner, may include restructuring the business via a process such as administration, or negotiating a structured repayment plan with creditors such as a company voluntary arrangement.

It is also possible to secure business finance to aid the company through a tight spot, to renegotiate terms with suppliers, or even sell assets which are no longer needed.

These kind of decisions require immense business savvy, but many company’s do survive balance sheet insolvency to emerge with a leaner, more profitable business on the other side.

What’s the Insolvency Process?

Insolvent companies in the UK must work with a licensed Insolvency Practitioner (IP). These are licensed and regulated individuals, often accountants, who are overseen by the Insolvency Service.

In the case of voluntary insolvency, a distressed company approaches an IP who will then review the situation and suggest a course of action. This is either a company rescue process, or a creditors voluntary liquidation, essentially the voluntary closure of the company.

In the event that a creditor forces the company into compulsory liquidation due to non payment of debts, an Official Receiver – An officer of the Insolvency Service – is assigned by the court to wind up the company.