Understanding Business Insolvency: Cash Flow vs. Balance Sheet Tests
Are you struggling with debt and unable to pay your creditors? If your business is in this situation, it is likely facing insolvency. This article will delve into the three principal tests that determine insolvency: the Cash Flow test, the Balance Sheet test, and the Legal Action test. We will also provide a detailed analysis of these tests, highlighting the perspective from a different view and offering a comprehensive understanding of which test to focus on when evaluating your business's financial condition.
Introduction to Business Insolvency
When a business is unable to pay its bills as and when they become due, it is considered insolvent. There are three main tests that determine if a company is insolvent:
Cash Flow Test
The Cash Flow test evaluates a company's ability to meet its financial obligations as they come due. A business is considered insolvent if it cannot pay its bills immediately or in the future.
Balance Sheet Test
The Balance Sheet test checks if the company's assets are less than its liabilities. Work-in-progress and stock levels must not be exaggerated, and any owed debts unlikely to be received must not be included.
Legal Action Test
The Legal Action test verifies if there are any outstanding court orders, statutory demands, or county court judgments (CCJs) against the company. If there are, the business may face compulsory liquidation, where creditors issue a court order to wound up the company.
Evaluating Insolvency: A Comprehensive Analysis
A common perspective on insolvency is provided by Victor Fong, although our analysis takes a different angle. Let's delve into the balance sheet and cash flow aspects of the insolvency test.
The Balance Sheet Test
From a balance sheet perspective, Victor Fong points out that liabilities exceed assets, indicating insolvency. However, we need to consider the timing of when these liabilities become due. For example, a home mortgage is significant, but it is not due all at once. Monthly installments are due, and as long as you meet those deadlines, you are not in default and meeting financial obligations as and when they become due and payable.
The Cash Flow Test
The Cash Flow test is more critical when determining insolvency. It involves analyzing the inflow and outflow of cash to determine if the business can cover its expenses. If a company fails this test, it must stop trading immediately to protect the interests of creditors and avoid making preferential payments.
Practical Analysis
Consider the following scenario:
50,000 in Accounts Payable: Due now or within the next 30 days. 48,000 Term Note: Due in 4.8 years from now, not a current debt. 50,000 Line of Credit: Fully drawn, with monthly interest. As long as there are sufficient funds to cover interest, this remains a non-immediate payable. 80,000 in Cash and Receivables: Assuming receivables are due within 30 days, and plant or equipment assets are not easily converted to cash.Calculating the Current Ratio (Current Assets / Current Liabilities), we get:
Current Assets 80,000
Current Liabilities 100,000 (50,000 Accounts Payable 50,000 Line of Credit)
Current Ratio 0.8 : 1 or 0.8
Generally, a Current Ratio of 1 or higher indicates solvency. Therefore, based on the Balance Sheet, the company appears to be insolvent.
Final Verdict: Focus on the Cash Flow Test
While the balance sheet indicates a negative net asset position and a Current Ratio of 0.8, considering the timing of liabilities, we should err on the side of the Cash Flow test. The cash flow analysis shows that the business has sufficient cash and receivables to meet its accounts payable, with approximately 30,000 left over after payment.
Thus, the business is likely solvent according to the Cash Flow test, provided cash flow management is maintained and there are no significant unforeseen expenses.
Conclusion
Insolvency is a significant issue for any business, and the right analysis can determine the appropriate course of action. While the balance sheet provides a snapshot of assets and liabilities, the cash flow is the lifeline of the business. Understanding and prioritizing the Cash Flow test can prevent unnecessary liquidation and allow businesses to continue operating effectively.