Frequently, the courts assess whether or not a company or individual is insolvent and if so, when that insolvency started and when various stakeholders should have suspected it.
Overview
The date of insolvency is also a critical factor for directors, when liquidators or creditors commence recovery actions for damages arising from insolvent trading or related claims.
In ASIC v Plymin (2003) 46 ACSR 126, the Judge referred to a checklist of 14 indicators of insolvency. These indicators were identified as:
- Continuing losses
- Liquidity ratio below 1
- Overdue Commonwealth and State taxes
- Poor relationship with present bank including inability to borrow further funds
- No access to alternative finance
- Inability to raise further equity capital
- Suppliers placing the debtor on cash on delivery (COD) terms, or otherwise demanding special payments before resuming supply
- Creditors unpaid outside trading terms
- Issuing of post-dated cheques
- Dishonoured cheques
- Special arrangements with selected creditors
- Solicitors’ letters, summonses, judgments, or warrants issued against the company
- Payments to creditors of rounded sums, which are not reconcilable to specific invoices
- Inability to produce timely and accurate financial information to display the company’s trading performance and financial position and make reliable forecasts.
Not every business that makes a loss, or a series of losses, is insolvent. When working capital is available to meet losses, insolvency can be avoided. Losses alone do not cause insolvency. Rather, insolvency is usually a combination of losses, and insufficient working capital.
Solely concentrating on losses without considering the company’s/business’s capacity to absorb those losses may not give a true picture of the solvency position. However, if the loss is significant enough, or over a long enough period, the ability of the company to absorb those losses is eliminated.
2. Liquidity ratio below 1
Liquidity measures the extent to which liquid assets are available to cover payable debts. A business liquidity ratio compares its current assets and current liabilities. If the ratio is greater than 1, this means there is more liquid assets than payable debts and indicates the business should be able to pay debts from its available assets. If the ratio is less than 1, the converse principle applies.
While the liquidity ratio provides a pointer to solvency, it is not a conclusive indicator. A liquidity ratio measures available assets at a specific time and does not factor in the dynamics of cash-flow or whether a debt is actually payable at that time. Some other factors that need to be considered is that the ratio usually uses funds in the bank, rather than allowing for possible borrowed funds and available overdraft facilities also need to be considered. Further, a liquidity ratio does not allow for whether some assets (such as stock and receivables) are truly liquid.
Business owners should examine the reasons for a liquidity ratio below 1, and decide whether action is needed.
3. Overdue commonwealth and state taxes
Many businesses regard the non-payment of taxes as the easiest way to save cash-flow and survive. This is commonly referred to as ‘borrowing the money from the government’. The rationale is that unlike general lending terms there are no application forms, no valuations, and no bank fees. In addition, there is no recourse of non-supply or repossession, and the application of interest can be delayed or negotiated.
Non-payment of tax commitments (GST or PAYG withholding) is a good indicator of insolvency. In most cases businesses that do not pay tax, cannot pay tax. Business owners should consider whether they are insolvent when taxes remain unpaid.
4. Poor relationship with present bank including inability to borrow further funds
Banks have a distinct advantage over other creditors. Banks know what funds are available and can analyse the flow of funds through a business account. If the business borrowed money from the bank, the business owners regularly provide the bank with financial information. Usually, none of this information is available to other creditors.
A poor relationship with a bank usually stems from:
1. The non-repayment of monies due
2. The bank regularly dishonouring cheques
3. The bank’s assessment of the financial position, or management of the business.
A poor relationship with a bank does not prove that the business is insolvent, just as a good relationship is not proof of solvency. The bank may also be unaware of a business’s insolvency, because the business has operated within the bank’s agreed limits, while not paying other creditors.
The bank’s lack of confidence in the business and its solvency can create a poor relationship. Certainly, if a bank refuses to advance further funds or calls up a loan or overdraft, its reason must be clear. If a bank refuses further funding it may, and often does, cause insolvency.
5. No access to alternative finance
Typically, two finance solutions are available to businesses in need of capital:
1. The debtor can convert short-term debt to long-term debt, which can be repaid on a certain date, or intermittently, over a period. If a debt is no longer ‘due and payable’ it will not form part of a strict solvency calculation.
2. Businesses may borrow funds to pay due debts. This creates a new debt to pay an old debt. Care must be taken not to mislead the lender, even if the loan is to satisfy the current debt and alleviate a current cash-flow problem. If the business later fails, the new loan may have personal liability consequences for the business owner.
6. Inability to raise further equity capital
An equity investor can inject funds into the business. Investors seek an eventual return from profits, and do not compete with the repayment priority of debts. Diligent equity investors will review the business finances and prospects to be satisfied that the return is commensurate with the risk.
An inability to use these finance solutions is a strong indicator that a business has a cash-flow problem and is possibly insolvent.
If business owners cannot get funding to pay outstanding debts, they should suspect insolvency.
7. Suppliers placing the debtor on cod terms, or otherwise demanding special payments before resuming supply & 8. Creditors unpaid outside trading terms.
Creditors are the first to know that their invoices are not being paid on time. An efficient business will have systems to identify overdue accounts, and prompt collection action. Collection may consist of collection letters, or calls, and limiting further supply to a cash on delivery (COD) basis, or ceasing supply entirely. Being placed on COD terms is a warning sign that the supplier is concerned with a business.
When there are many creditors with outstanding accounts, suspicion may be aroused that a business is insolvent. However, some businesses may habitually pay late, even when they have sufficient funds.
Business owners must determine whether debts are unpaid because there is no money, or whether there is another reason.
9. Issuing of post-dated cheques
Issuing a post-dated cheque for a current debt is a classic sign of insolvency.
Understandably, some creditors view a post-dated cheque as a sign that their account will eventually be paid. However, issuing a post-dated cheque amounts to an admission of insufficient funds to pay at that time. Whether it also amounts to a creditor extending credit terms to the cheque date—is far less certain.
Solvent debtors rarely issue post-dated cheques. Therefore, these cheques should immediately raise suspicions of insolvency.
A debtor with a long history of issuing post-dated cheques is almost certainly insolvent and is relying on future monies to pay current commitments. Conversely, a debtor who infrequently resorts to post-dated cheques is more likely suffering a short-term, cash-flow problem, rather than insolvency.
10. Dishonoured cheques
Many post-dated cheques are dishonoured upon presentation. Generally, a cheque is dishonoured because there are insufficient funds available to cover the payment. On occasion, cheques can be dishonoured through no fault of the debtor. Therefore, one or two instances of dishonoured cheques should not be taken as clear evidence of insolvency.
However, when a debtor’s bank repeatedly dishonours cheques a conclusion of insolvency is unavoidable. Business owners must quickly establish why their cheques are dishonoured, and determine if the business is solvent or not.
11. Special arrangements with selected creditors
Not all creditor demands end in court summons and judgments. If a debtor does not dispute a debt, but cannot make immediate payment, a creditor may enter into a repayment agreement.
Entering into a repayment agreement is an admission that a business cannot meet the full debt when due. Commonly, repayment agreements are successful and both parties are satisfied with the outcome.
A debtor can cure its insolvency by negotiating extended payment terms with a creditor provided the creditor makes a clear agreement to extend the terms. Once the debt terms are extended, the full amount is no longer due and payable.
12. Solicitors’ letters, summonses, judgments, or warrants issue against a company
One letter of demand from a creditor (or their solicitor) is not proof of insolvency, as there may be a dispute between the parties. However, a series of demands from various solicitors should create a strong presumption of insolvency. It is unusual for a business to have several disputes with their suppliers at the same time.
If the creditor progresses beyond the demand stage and obtains a judgment that remains unpaid, the presumption of insolvency is all but confirmed. When execution of the judgment is undertaken by the creditor, a state of insolvency is certain.
13. Payments to creditors of rounded sums, which are not reconcilable to specific invoices
Round payments can be made to reduce a debt, if the creditor agrees. However, it is common to find round amount payments being made without an agreement. Round payments are usually made because the debtor cannot pay the debt in full, and cannot negotiate extended arrangements with creditors, and extended credit terms become implied through part-payment. If business owners use small amounts of cash to pay large debts, they are likely to be insolvent.
14. Inability to produce timely and accurate financial information to display the company’s trading performance and financial position and make reliable forecasts
Sections 286 and 588E of the Corporations Act 2001 consider the issue of deeming a company is insolvent due to not keeping proper books and records.
If the company has failed to keep financial records in accordance with section 286 of the Corporations Act the company is to be presumed insolvent for the period to which the records have not been kept as required.
While the fact that the company has not prepared accurate financial statements may not necessarily mean that a company is insolvent, the courts have noted that a correlation exists between insolvency and deficient financial records. Not only do insolvent entities largely have inadequate accounting records, they also frequently show a reluctance to prepare reliable, and timely accounts.
Commonly, without financial information, business owners do not know the extent of the deficiency and will be unable to convince bankers, or other creditors, that they have a solution to their problem.
Summary
How long can a short-term cash-flow problem last before it becomes a case of insolvency? A shortage of funds can only be described as a short-term cash-flow problem if it is certain it will be overcome in the short-term. Placing a timeframe on overcoming the problem is difficult, as some cash-flow problems are seasonal, or caused by specific contractual factors.
However, as a general rule a short-term cash-flow problem should be solved within three or four months with all debts being paid.
Disclaimer
The enclosed information is of necessity a brief overview and it is not intended that readers should rely wholly on the information contained herein. No warranty express or implied is given in respect of the information provided and accordingly no responsibility is taken by Worrells or any member of the firm for any loss resulting from any error or omission contained within this fact sheet.
Last Updated: 3.11.2017
