A company can be said to be insolvent on any one of four tests: the cash flow test, balance sheet test (negative asset value), an unsatisfied judgement (usually a county court judgement) or an outstanding statutory demand.
Of these four, the most crucial is the cash flow test which looks at whether a company can pay its liabilities as and when they fall due where late payment of creditors indicates that a company is suffering cash flow problems.
Running out of cash is the cause of most business failures and it happens chiefly for three reasons: the bank freezing the company account, a restriction in the company’s ability to draw down funds possibly due to the lack of available credit and thirdly, a sales ledger issue where the company can’t draw down funds from factoring either because invoices have not been logged, or because of declining sales, or overdue or disputed invoices.
If the company’s relationship with its bank is under pressure then the causes and effects must be examined. Banks generally would prefer not to close down businesses and only usually start to get tough if a business consistently tests its overdraft limit, company cheques cannot be honoured and the business does not communicate or provide sensible financial information if asked for.
It may be that the company is forced into an onerous factoring arrangement that will benefit the bank but can reduce funds available putting further pressure on cash flow.
If the sales ledger system is not being kept up to date accurately or there are issues with suppliers over invoices then the system needs to be looked at thoroughly and a more robust set-up may need to be put in place.
In terms of cash outflow, there are two main tensions that can result and they are the inability to pay outstanding bills and the inability to pay future bills. In this situation prioritising payments becomes essential. This is critical if a company has decided it is insolvent because it must act in the best interests of its creditors and needs clear principles for making payments to avoid personal liability.
In these circumstances unless a company is familiar with this sort of situation it would be advisable to take advice from a specialist restructuring adviser, who will have a number of strategies available to help and it may be that at its core there is a viable business waiting to be unlocked.
A cash flow crisis is an alarm bell sounding that should indicate that the business needs to be properly assessed with experienced outside help.