What does insolvency mean?

Insolvency is defined as when a company is unable to pay its debts as they fall due or where its liabilities exceed its assets. The term is used for both businesses and individuals. 

Whilst an obviously bad position for a business to be in, it does not spell absolute disaster. This article examines how you can find out if your company is insolvent, how one might avoid insolvency, and finally how to deal with it should it be unavoidable.

How do I know if my company is insolvent?

If your company has reached a state of insolvency, it is likely that the business will be under a lot of pressure, and it’s possible that it has gone unnoticed. Insolvency often creeps up, after a series of setbacks, making the shock all the worse. There are several tests to see if your company is insolvent. The two main ones, the cash flow and balance sheet tests, are carried out as follows:

1. Cash flow test. The cash flow test is simple; it ascertains whether or not you are able to pay your outgoings on time. If it finds that you are unable to, then your company is insolvent.
   
2. The balance sheet test. The balance sheet test is slightly more investigatory. It examines the value of all the company’s assets, adds them up, then deducts the sum of the debts from that number. If the result of this equation is negative – if the debts are greater than the assets – the company is insolvent.

How to deal with insolvency 

The best way to deal with insolvency, obviously, is to avoid it in the first place. If your business is losing money, for any number of reasons, then this needs to be stopped.  This might involve increasing turnover, reducing costs, increasing prices etc.   Failure to take action will ultimately result in insolvency.

However, if these steps, for whatever reason, have not been taken, you’ll need a way of dealing with it. 

Failure to deal with insolvency can result in the forced liquidation of the assets of the company, in order to pay the creditors. Continuing to trade whilst knowing that the company is insolvent can have drastic legal ramifications; as a director, your duty is to care for the best interest of whoever holds a stake in the company under your control. In times of solvency, this duty is to the shareholders, to run the company as will best benefit them. 

When a company becomes insolvent, that duty transfers to creditors. Neglecting your fiduciary duty to either party can lead to civil, and even potentially criminal sanctions (if the party is HMRC) being brought against you. 

This may sound drastic, and it certainly has the potential to become so – but thankfully, a company becoming insolvent in and of itself, when not compounded with knowledgeable negligence, is not a lost cause.

First of all, you need to make sure that you minimise any damage done. Steps to take, or avoid, include:

• Avoid increasing the company’s debt. This may sound obvious, but it’s extremely important. 
• Avoid transferring assets to a new company. This will not put them out of reach of a liquidator, and could have serious ramifications for any directors responsible. 
• Avoid not paying tax. Again – this might sound obvious, but if a company is insolvent, HMRC are responsible for more forced liquidations than any other institution, and they can pursue directors personally for some debts incurred..

Insolvency proceedings

If you conclude that the company is insolvent and that you cannot restore solvency by putting more money into it or by generating profits and cash quickly enough you will need to consider which insolvency proceedings to initiate.  This is an umbrella term covering various insolvency processes including moratorium, restructuring plan, administration, company voluntary arrangement (“CVA”), winding up being either creditors voluntary liquidation  (“cvl”) or compulsory liquidation /  winding up, and receivership.  The term bankruptcy only refers to the insolvency of individuals but is often wrongly applied to companies and you will often hear people say that “ a company has gone bankrupt”.

Insolvency practitioner

Insolvency practitioners, or IPs, are experts who are licenced to act on behalf of insolvent businesses. Being experts in business rescue and distress, IPs will provide advice on all the options available to the company and once a decision has been made, implement the chosen process.  The outcome may be the survival of some or all of the business, although this is not always possible.

Options

Company Voluntary Agreement.

One of the options that may be chosen is a Company Voluntary Agreement (“CVA”). This essentially constitutes a structured and affordable debt management plan, aiming at paying back creditors some or all of the debts, over a suitable time frame while giving the company scope to continue trading.

Liquidation

Liquidation – both voluntary and compulsory – are terminal processes, after which the company will cease to exist. It involves the IP liquidating and then distributing the assets to the creditors. There are two different types of liquidation:

1. creditors voluntary liquidation (“CVL”) – is used by responsible directors to close down the activities of a company in an orderly manner by an IP selected by the shareholders and approved by the creditors allowing the directors to control the initiation of the process.
2. Compulsory liquidation or compulsory winding-up.. This type is ordered by a court issuing a winding up order upon a petition issued by one of its creditors. It is certainly a sub optimal position to find oneself in as a director, with control of the process being passed on to a civil servant, the Official Receiver, and then potentially an IP chosen by the creditors, depending on assets.  

Administration

Administration aims to salvage a company, or some or all of its business, or to achieve a better outcome than if the company was wound-up immediately. The process is overseen and controlled by an IP.

What to do?

The most important thing to do as a director facing insolvency, both practically and legally, is to seek the professional help of a licensed insolvency practitioner to explain the options in a clear manner, for you to be able to make the right decisions for moving forward.

If you require further advice or simply need further clarification, give our team a call today on 0113 242 0808 or e-mail advice@chamberlain-co.co.uk