The solvency or insolvency of a company is typically considered in terms of and assessed by one or other (or a combination) of two measures – the “balance sheet” test and the “cash flow” test.
Balance Sheet Test
The balance sheet test considers whether a company’s liabilities are greater than the realisable value of its assets. Using this approach, a company is insolvent if the estimated realisable value of the company’s assets is less than the amount of its liabilities.
Cash Flow Test
The cash flow test considers whether a company is able to pay its debts as and when they fall due. This test focuses on the resources that are available to the company and the obligations and demands it has to meet now and in the near future.
The cash flow test is an important element in any determination of solvency (or insolvency) in many jurisdictions, including Hong Kong, BVI, Cayman Islands and Australia.
The following should be considered for a cash flow test of solvency:
- whether a company is able to pay its debts as and when they fall due is a question of fact and it is to be determined as a matter of commercial reality in light of the prevailing business practice of the company;
- to remain or be considered solvent, a company is not required to have cash ready to cover its commitments as they fall due for payment. The company must have readily realisable assets, which can be realised (by sale, mortgage or pledge) into cash in time or other liquid resources to meet the payment of debts;
- an assessment of whether a company can pay its debts also considers the nature and circumstances of the company’s activities, the nature of the company’s assets and liabilities and the company’s historic conduct in paying the debt under consideration and its debts generally;
- insolvency is not to be found or inferred simply from a temporary lack of liquidity. Nor should it be assessed as if the company has to keep cash reserves sufficient to meet all outstanding indebtedness, however distant the date of payment may be; and
- the company’s ability to pay its debts is determined not only by reference to debts payable as at the relevant date, but also by reference to its ability to pay debts that will fall due for payment sometime in the near future.
Insolvency Red Flags / Indicators
Any solvency analysis will be assisted by identifying the following red flags / indicators of insolvency:
- a history of continuing losses;
- low levels of available cash;
- lack of interested buyers for the company’s major businesses and/or assets;
- inability to raise funding;
- non-payment of statutory charges, fees and taxes;
- issue of statutory demands or commencement of legal proceedings by creditors;
- suspicious or improper transactions;
- uncooperation of company management; and
- troubled companies operating in the same industry and/or economy.
When is a Solvency Analysis Required?
A solvency analysis may be required when:
- assisting directors to meet their statutory and other duties and obligations in respect of the solvency or insolvency of a company;
- assessing banking and investment obligations and covenants;
- assessing the options available to a company when considering a restructuring and related options; and
- assessing legal claims.