The two insolvency tests every director should run this week

A company is insolvent when it cannot pay its debts as they fall due, or when its liabilities exceed its assets, and the law expects you to know which of those applies to yours.

Why the definition matters to you personally

Most directors think of insolvency as something that happens to a company, like a flood. It is not. It is a line, and the law cares a great deal about which side of it you are standing on, because your duties change when you cross it.

While the company is solvent, you run it for the shareholders. Once you know, or ought to know, that it cannot avoid insolvent liquidation, you run it for the creditors. Every decision after that point is judged against that standard: did it make the creditors’ position better or worse? Trading on, paying yourself, paying one creditor ahead of another, selling an asset, all of it. If you did not know where the line was, you cannot show you were on the right side of it.

So the tests are not academic. They are the first thing a liquidator reconstructs and the first thing a court asks about. Run them yourself, now, with real numbers.

Test one: cash flow

Can the company pay its debts as they fall due?

This is the test from section 123 of the Insolvency Act 1986 and it is the one that matters most for a trading company. It is not asking whether you will eventually be fine. It is asking whether, over the next few weeks and months, the money coming in covers the money that has to go out when it is actually due.

Run it like this. Take a sheet of paper or a spreadsheet. Down the left, every payment that is due in the next 13 weeks, by week: PAYE and NIC, VAT, rent, the Bounce Back Loan instalment, supplier invoices by due date, wages, loan repayments. Across the top, the weeks. Then add the cash you actually have and the cash you are confident will arrive, by week, from invoices already raised and contracts already signed. Not the pipeline. Not the deal that is nearly done.

If the balance goes negative in any week and stays there, the company is cash-flow insolvent. If you are only keeping it positive by not paying HMRC, the company is cash-flow insolvent and you already knew it.

Some markers that the answer is yes even before you do the sums:

• VAT or PAYE has been paid late more than once.
• A supplier has stopped supply or moved you to pro forma.
• You are choosing which creditors to pay each month.
• You have had a statutory demand, a county court claim or a bailiff visit.
• Directors have stopped taking salary to keep the company going.

Test two: balance sheet

Are the company’s liabilities, including contingent and prospective ones, greater than its assets?

This is the second limb of section 123. Take the last balance sheet and update it to today. Then be honest about the assets. Stock at what it would fetch, not cost. Debtors less the ones who will not pay. Goodwill and development costs at nothing. Plant and vehicles at trade value. Then add to the liabilities the things that are not on the balance sheet yet: the dilapidations claim at the end of the lease, the redundancy costs if you stop trading, the tax on the directors’ loan, the guarantee you gave the landlord.

If liabilities exceed assets on that basis, the company is balance-sheet insolvent. Many trading companies are, for a period, and survive it. But if it is true at the same time as the cash-flow test, there is no realistic argument that the company is solvent.

The third question: is there a way out?

Failing a test does not by itself mean you must stop trading. The question the law asks next is whether there is a reasonable prospect of avoiding insolvent liquidation. A signed contract that transforms the cash flow, an investor with funds confirmed, a creditor who has agreed in writing to a repayment plan: these are reasonable prospects. A hope, a conversation, a deal that is nearly done, are not.

If there is a reasonable prospect, you can trade on, provided you take every step to minimise the loss to creditors and you can show you did. Keep minutes. Record the decision, the reason, and the date. The record is what protects you later.

If there is not, the duty is to stop increasing the creditors’ losses, which usually means stop trading and take advice. Continuing past that point is wrongful trading, and it is the main route to directors being made personally liable for company debts.

What switches on when you cross the line

• The creditors come first. Shareholders’ interests, including yours, drop to the bottom.
• Preferences become reversible. Paying a creditor you favour ahead of the rest can be unwound by a liquidator looking back six months (two years for connected parties).
• Undervalue transactions become reversible. Selling or giving away assets for less than they are worth can be unwound over two years.
• Your conduct is on the record. A liquidator will report on it. Disqualification is the sanction for the worst of it.

What to do today

1. Build the 13-week cash flow with real due dates. It takes an afternoon and it answers test one.
2. Update the balance sheet with honest asset values and the liabilities that are not yet on it.
3. Write a dated note of the result and what you have decided to do about it. Put it with the company’s records.
4. If either test fails and there is no confirmed way out, speak to a licensed insolvency practitioner this week.