Insolvency Indicators

Relevant legislation refers to insolvency as:

A person is solvent if, and only if, the person is able to pay all the person’s debts, as and when they become due and payable. A person who is not solvent is insolvent- Section 95A of the Corporations Act 2001 and Section 5 of the Bankruptcy Act 1966.

There are two (2) common meanings of ‘insolvency’:

  • Cash-flow insolvency – being unable to pay debts as and when they fall due.
  • Balance-sheet insolvency – assets being exceeded by liabilities.

Commonly regarded indicators of insolvency, as established in ASIC v Plymin (2003) 46 ACSR 126 include:

1. Continuing losses

A series of trading losses can lead to or be indicative of a shortage of working capital. A prolonged period of trading losses will likely reduce a company’s capacity to pay its debts when they fall due.

2. Liquidity ratio below 1.0

The two most commonly used liquidity ratios include the current ratio (current assets ÷ current liabilities) and the quick ratio (cash & cash equivalents + accounts receivable ÷ current liabilities).

The current ratio examines a company’s ability to access funds in the short term from current or “liquid” assets to meet short-term liabilities. An on-going current ratio of less than 1.0 indicates that a company has not maintained sufficient assets to meet the day-to-day obligations of creditors and that it may be insolvent and not able to pay its obligations to creditors as and when they fall due and payable.

The quick ratio examines the ability of a company to pay its debts by using its cash and near cash equivalents (i.e. accounts receivable and marketable securities). A quick ratio of less than 1.0 indicates that a company would not be able to repay all its debts by using its most liquid assets and that it may be insolvent and unable to pay its obligations to creditors as and when they fall due.

3. Overdue Commonwealth & State taxes and Statutory obligations

The failure to lodge tax returns on time and the failure to maintain its payment obligations can be an indicator that a company is not able to meet all of its statutory obligations as and when they fall due. Often when a company is experiencing difficulty in meeting its obligations to trade creditors, it will neglect its taxation obligations to assist with cash flow.

An employer is also required to pay superannuation contributions to the relevant employee superannuation fund within twenty-eight (28) days of the quarter end, under Superannuation Guarantee Charge legislation. Similarly, superannuation obligations are often neglected in order to assist with trading cash flow.

4. Poor relationship with present bank including inability to borrow additional funds

A Bank has a unique relationship as it will usually be aware of the cash position of a company and may have access to a company’s financial information in circumstances where a company has borrowed money. A Bank’s actions such as the dishonouring of cheques, rejection of finance or the immediate calling of bank loans will come as a result of a lack of confidence in the company’s financial position. A Bank failing to extend further credit to a company usually stems from a history of delayed repayment or defaults of monies due to the Bank, and/or the Bank’s assessment of the financial position/capability/viability/management of the business.

5. No access to alternative finance.

A company can seek to replace current debt with perhaps longer-term debt, usually borrowed on more relaxed lending criteria, however on less favourable terms (i.e. higher interest rates). Any incoming financier would make that same financial assessment of a company as the current financier when extending credit. Similarly, inability to source alternative finance from another provider does not bode well for the company’s financial sustainability.

6. Inability to raise further equity capital

Equity capital is another form of financing that allows a company to gain access to cash. Potential equity investors, knowing that an eventual return may be delayed or uncertain, are likely to be diligent in reviewing the finances and prospects of a company in an effort to be satisfied that the return is commensurate with the risk. It is of concern if current shareholders are not willing to increase their stake in the company to ensure its future viability. It must be noted that a lack of investor confidence may be due to a number of reasons, including a lack of desired profitability, rather than solvency concerns.

7. Supplier placing the debtor on ‘cash-on-delivery’ (COD) terms, or otherwise demanding special payments/arrangements before resuming supply

These are both clear indicators of a deterioration of a company’s trading relationship with suppliers and its ability to meet its on-going liabilities. Where suppliers amend the terms of trade with a company to COD it usually suggests that the creditor has no faith in the company’s ability to meet further commitments. Similarly, requests for special payments/arrangements will usually come as a result of a supplier’s fear of non-payment and seeks to impart their own desired terms to ensure repayment.

8. Creditors unpaid outside trading terms

If a significant portion of a company’s aged payables are outside normal trading terms (usually 30 days, depending on the industry), it is a sign of an inability to satisfy its debts when they fall due. This is a telling indicator of cash flow insolvency.

9. Issuing of post-dated cheques / dishonoured cheques

This is clear evidence that a company does not have the current capacity to pay its debts which are due, and seeks to pay its current obligations with future cash inflows.

The issuing of post-dated cheques shows that a company has extended past its current cash resources in attempting to satisfy its current debts.

10. Payments to creditors of rounded figures, which are irreconcilable to specific invoices

Lump sum (round) payments are evidence that a company does not possess sufficient cash to meet its obligations as and when they fall due and instead resorts to making payments based on the cash available at the time, rather than payments for specific invoices within trading terms. Entering into such an arrangement is usually an admission that the business cannot meet the full debt when due, otherwise the arrangement would not be necessary.

11. Solicitors’ letters, summons(es), judgments or warrants issued against the company

The issuing of demands by solicitors is usually an indication that a creditor has exhausted all avenues to recover its outstanding debt and has sought the assistance of an external third party to assist with collection.

Numerous demands from a number of solicitors will create a strong presumption of insolvency. Debts which are long overdue and have reached the stage of legal recoveries are a clear sign that a company is not able to repay its debts in a timely manner.

12. Inability to produce timely and accurate financial information to display the company’s trading performance and financial position, and make reliable forecasts.

A company is obligated to keep financial records that correctly record and explain its transactions and enable the preparation of true and fair financial statements pursuant to Section 286 of the Corporations Act. However, should a company fail to maintain this obligation then it is presumed that it is insolvent according to Section 588E of the Corporations Act. The mere fact that a company does not keep financial records does not necessarily mean that it is insolvent. However, Courts have come to the conclusion that companies in financial distress will normally have records in disarray. Historically, an insolvent company usually does not have reliable financial information up to date and readily available. Reluctance to update financial accounts is usually a product of directors avoiding the realisation that the company is in fact insolvent.

A company exhibiting a few of the above indicators may not necessarily be terminally insolvent, but may be simply experiencing short-term cash-flow problems. If numerous indicators are identified over a prolonged period of time, it then may be the case that the company is insolvent and consultation with Cor Cordis is recommended to assess your options.

Once insolvency is established, it can lead to some serious legal consequences for a company or individual. For example:

  • They may be subject to Court proceedings for liquidation or bankruptcy.
  • Penalties and civil recoveries can be triggered against directors should the company continue to trade on and incur debts (that is, directors can be exposed to an insolvent trading claim by a Liquidator).
  • Insolvency may be an event of default in a business contract, at the detriment to the company.