What is the Difference Between Balance Sheet Insolvency and Cashflow Insolvency?

May 16, 2019

In 2016, Ben Kay (not his real name) founded a small construction company, specialising in high-end residential home additions. Kay had a strong trade background but wasn’t overly experienced in running a business.

Kay’s first three years went well. He acquired a steady stream of customers, cultivated a strong reputation for quality and grew his turnover to around £500,000. Growth was steady and the business’ small profits provided for Kay and his family.

In early 2019, Kay’s accountant broke some worrying news: the business was insolvent.

Kay had recently underpriced a huge job, which had thrown his finances into the red. He said the call from his accountant was shocking as aside from one mispriced job, it felt like his business was doing well. Hearing that his company was insolvent felt like a punch in the gut.

Thankfully, Kay sought out advice from an insolvency practitioner, who ultimately helped save his business.

From the outside, it might seem strange that a director could get their company into an insolvent position without noticing—but it happens a lot. Directors are often so busy actually running their company that they leave the financial administration to their accountant, who only looks at their books every six months or so.

In this article, we’ll look at what insolvency actually is and two tests you can use to determine if your company is insolvent.


What is balance sheet insolvency?

Balance sheet insolvency works by weighing your current assets to your current liabilities. If your assets outweigh your liabilities, you’re solvent. If your liabilities outweigh your assets, you’re insolvent.

Here’s the technical explanation from the UK Insolvency Act 1986: “[A] company is also deemed unable to pay its debts if it is proved to the satisfaction of the court that the value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities.”


What is cashflow insolvency?

The second test for insolvency is cashflow insolvency and it’s a fair bit simpler than balance sheet insolvency. This test investigates the amount of working capital (money you have accessible) related to your debts. Specifically, it looks at your ability to pay your debts when they fall due.

If you can pay your debts when they fall due, your company is solvent. If you cannot pay your debts, your business is insolvent.

While an inability to maintain payments is a huge red flag, it’s not the end of the world. With careful management, it’s possible to fix the problem and get your business back on track.

cashflow insolvency


Cashflow insolvency is often what catches out business owners

Contrary to what one might expect, many companies experiencing cashflow insolvency are profitable and growing companies who suddenly go bust.

So how does a company go from being on a healthy growth trajectory to suddenly running out of money? What often happens is a profitable company will take on a big new client. With the business owners keen to jump the chance and pursue the extra profit, no one takes a deeper dive into calculating the long term financial viability of the deal and how to swing this in the cashflow, short term.

For example, when a production company signs a big new client, there can be a lot of initial expenses such as stock, raw materials and PP&E that need to be paid. Here, initial costs can quickly exceed the credit terms a company has with its suppliers and so they are forced to pay upfront, not to mention that the company also still have to pay the staff working on the project. All these costs combined can accumulate to a significant sum of money that will have to be paid out of cash reserves, sometimes long before the customer pays the bill. This can be exacerbated by large customers having a strong bargaining power and insisting they’ll only give the business the contract if they get extended credit terms.

When a typical SME takes on big new business, the scenario often unfolds in one of three ways:

  • The company run out of cash way before the new job has been delivered and paid for, leaving them insolvent
  • The company haven't considered what happens if the new customer doesn't pay them for whatever reason, leaving them insolvent
  • The company have carried out comprehensive financial forecasting and make it to delivery date with healthy cash flow, leaving the company still solvent


What should I do if my business is insolvent?

If either the balance sheet test or cashflow test indicates that your business is insolvent (or you believe it is at risk of becoming insolvent), you should seek insolvency advice from a regulated and licenced insolvency practitioner as quickly as you can.

The sooner you take advice, the more time you give your advisor to work and the better the chances of a successful recovery.

When you seek advice, your insolvency practitioner will analyse your business’ circumstances then recommend the best course of action moving forward. If you are worried about insolvency, contact our team today for free, confidential and non-judgemental advice. We will quickly investigate your specific circumstances and discuss what options are available to you.

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