Understanding insolvency
In the United Kingdom, insolvency is when an individual or business is unable to repay their debts. This can happen for a number of reasons, such as financial mismanagement, unexpected expenses, or simply taking on too much debt. When an individual or business is insolvent, its creditors may take legal action in order to recoup their losses. This can result in the individual or business having their assets seized and sold, or being forced into bankruptcy. Insolvency can be a difficult and stressful process for those involved, but there are options available to help individuals and businesses through this difficult time.
Insolvency is the legal term describing the situation of a debtor who is unable to pay his, her, or its debts. There are two primary types of insolvency: cash flow and balance sheet.
Insolvency law policies allow a viable but financially troubled company to restructure instead of filing for bankruptcy.
A business is considered to be in a state of insolvency when it is unable to pay their debts. The more debt a Company is in, the greater their Insolvency Risk.
They actually mean the same thing, the word insolvency is only used to refer to a Limited Company going bankrupt, whereas bankruptcy is used more for companies that are not Limited i.e. sole traders and partnerships or non-business entities i.e. an individual not being able to pay back debt for money borrowed for personal reasons.
Not at all. At any given point a company doesn’t have enough money to pay the debt, it is considered insolvent, but that does not necessarily mean it can’t pay off debt. It could be that they are waiting on a payment before they can pay their debt. As soon as that payment comes in the company becomes solvent again.
In theory, this is how insolvency works, however generally speaking, when insolvency is mentioned it is assumed the business has no means to pay off debt.
Insolvency is calculated using a Corporate Insolvency Test.
The Corporate Insolvency Test is a method used to determine a company’s ability to meet its liabilities as they fall due, and whether the total value of its liabilities exceeds assets.
Is a Company Director personally liable for company debts?
In usual circumstances a Director is not liable for Company debts except for the following reasons:
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His or her own PAYE and National Insurance contributions
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Income tax on any cash taken from the company
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Personal guarantees given to the company i.e. a legally binding promise to pay back any company debt using your personal money, should the company be unable to keep up with repayments
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Any fines for being guilty of wrongful trading
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Any fines for being guilty of misfeasance
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Any fines from being guilty of fraud.
Cash flow insolvency is when the debtor suffers from a lack of financial liquidity, making it impossible to pay debts as they fall due. In layman terms, cash flow insolvency is when a business isn’t making enough money to pay for its debts on time.
You should take a cash flow test. The cash flow test looks at whether a business can pay its liabilities on time. To do this, you must look at your business’ predicted income and your current expenses and any expenses that are due in the near future. If the business’ predicted income can’t pay for the business’ expenses, then there is a chance you could become cash flow insolvent.
Balance sheet insolvency, also known as accounting insolvency is where one’s liabilities exceed their assets. This form of insolvency normally occurs prior to a company filing for bankruptcy.
You should take a balance sheet test. The easiest way to do a balance sheet test is to ask your bookkeeper or accountant to produce a balance sheet for your business.
If you don’t have a balance sheet available, here’s what to do.
List all the assets your business has. This should include stock, monies owed to you, cash, money in the bank, property, vehicles, and machinery.
Now, list all your business’ liabilities such as loans, money owed to HMRC, your employees, suppliers, and any other trade creditors.
If the money owed (liabilities) are more than your assets, you are technically balance sheet insolvent.
The root cause of insolvency is down cash flow issues. Specifically, it means not enough cash is coming into the business to pay expenses and debt. Cash flow problems can happen for a variety of reasons, some of them include
- Market conditions.
- Missed or delayed payments by debtors (the organisations that owe you money).
- Increased competition and the resulting reduction in revenue.
You can do the insolvency test (cash flow or balance sheet), as mentioned above. Generally, you will know you are insolvent (or heading towards insolvency) because you find it a struggle to pay your expenses and debt.
How to avoid insolvency
Sometimes insolvency cannot be avoided because of factors not under your control e.g. market conditions or your debtors not paying you back on time. However, as a Company Director, you can take the following measures to keep your business as financially healthy as possible:
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Know your limit: avoid taking on more debt than you can handle. Do not stretch yourself to beyond the limits, when borrowing.
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Incentivise your debtors to pay you back earlier such as through an early payment discount
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Review your finances regularly to know where you stand.
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Consider giving up equity instead of acquiring debt. This means selling small stakes in a business (shares) to raise funds. It reduces the percentage of the company you own but reduces debt. There is a balance to maintain between debt and equity.
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Keep a tab on spending and identify needs versus wants.
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Get advice from an expert in financial health.
An insolvent business cannot pay off its debt, therefore, it is likely that Creditors are chasing monies owed and perhaps considering legal action to extract sums.
The next step would be to bring in an Insolvency Practitioner (IP) who may be able to help the business recover.
An insolvency proceeding is a process that takes place when an organisation or individual are no longer able to meet their financial obligations and pay their Creditors when debts are due.
An insolvency practitioner is someone who is an expert in business rescue and recovery. They will legally take charge of an insolvent business to help it recover and pay off its debt.
An insolvency practitioner may be hired by the Directors of the struggling company or its Creditors.
Regardless of how the insolvency practitioner is appointed, their job is to act in the best interest of the Company.
An insolvency practitioner can be appointed by the struggling company themselves or via Court, in cases where Creditors take legal action to reclaim the debt.
Insolvency Practitioners: How can they help me and my business?
An insolvency practitioner can help in a variety of different ways, it all depends on how severe the financially difficult is for a business. Some example may include:
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To negotiate with your Creditors, on your behalf, to arrange for new payment terms that are affordable for the struggling business. This is done by a process called a Company Voluntary Arrangement (CVA). Typically, creditors will write off a portion of the debt with the promise that a remaining portion will be paid off.
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Putting the company into Administration. This is similar to CVA, except that the IP finds a way to pay off the entire debt. This will likely involve selling off company assets to repay creditors.
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Putting the company into Liquidation. In the most severe of cases, an IP will bring the company to a close by selling off all assets and paying back as many Creditors as possible.
A Company Director is counted as an employee of the business, therefore he/she is also a Creditor to the business with respect to the salary owed. They will be paid that salary and are treated as a Preferred Creditor i.e. a Creditor that is to be paid back before others.
Any money raised through insolvency proceedings will be first used to pay the insolvency practitioner.
If appointed by the Court / Creditors, this is legally binding and you cannot change.
That could constitute fraud, which incurs criminal charges. It is better to not to do anything yourself.
Is there an order at which Creditors are paid?
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The insolvency practitioner brought in is paid first.
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An entity that had lent the company money against a company asset e.g. if a bank lends money secured on a building, it means that asset effectively belongs to the bank and they can do what they want with it. These are known as secured creditors who have a fixed charge over an asset.
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Employees (this could include the Company Director).
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Secured creditors with a floating charge over an asset. These are loans secured against assets that don’t have a fixed charge e.g. stock because its value regularly fluctuates.
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Unsecured creditors, those who lent money that was not secured against any company asset.
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Shareholders.
If your insolvency leads to bankruptcy / liquidation, it will stay on your credit file for six years.
The maximum term of a Personal Insolvency Arrangement (PIA) is six years. this can be extended by up to an additional year in certain circumstances. A PIA can only be obtained once in your lifetime and can only be sought through a Personal Insolvency Practitioner.
Personal insolvency is when you are made bankrupt due to personal debt, not Company debt. Although, your position at a Company may be affected by bankruptcy.
This means they must be paid before certain other debts. As full payment cannot be guaranteed, there are special arrangements for employees to claim the basic minimum of debts owed to them from the National Insurance Fund.
Thereafter, employees are likely to be made redundant.
If you are made bankrupt, your details will remain on the register for three months after you are ‘discharged’. This is when you are no longer responsible for debts you accrued before going bankrupt and are relieved from restrictions enforced during the bankruptcy period.
The IIR is an amalgamation of the individual insolvency, bankruptcy restrictions and debt relief restrictions registers. The Insolvency Service is required by statute to maintain these registers, keep them up to date and make them available for public inspection.
The Insolvency Service is a government agency the help support those in financial distress, tackles financial wrongdoing, and maximises returns for creditors. Their primary job is to administer compulsory company liquidations and personal bankruptcies. The Insolvency Service also deals with company misconduct by investigation, including redundancy payments for insolvent companies.
They also regulate Insolvency Practitioners.
Contact the Insolvency Enquiry line on 0300 678 0015.