What Is Company Insolvency?

Learn what insolvent companies are, what causes them, and ultimately, how you can avoid having to cease trading immediately.

Updated: January 17, 2024
Matt Crabtree

Written By

Matt Crabtree

|
Rebecca Goodman

Edited By

Rebecca Goodman

 

Whether you're someone who currently owns a business — regardless of the size — an investor, or just someone with a general interest in corporate finance, it's important to understand what an “insolvent company” means.

In a nutshell, if a company is insolvent it means they are not able to pay off their debts and they are higher than the firm's assets, it's a bit like bankruptcy for businesses.

In this article, we'll be taking a closer look at everything you need to know regarding company insolvency when you're running a business — covering things like what it means, how it's caused, and how it impacts a business.

Defining company insolvency

Generally speaking, an insolvent company is a business that's not able to meet all of its financial obligations. It will be one that is no longer able to pay all of its debts (including things like employee wages, supplier expenses, and utility bills)

Obviously, this is typically one of the worst situations a firm can find themselves in and it happens whenever a company's liabilities end up outweighing all the assets it holds, creating a pretty precarious financial position for everyone involved.

That's why it's worth knowing how to recognise the signs of insolvency before it's too late and Companies House takes your business off the register.

The company's financial position

If your company is bordering on becoming insolvent, prevention is the key and you'll want to make sure you're keeping a close watch on your finances. At the earliest point you will need to determine whether your company has enough assets to compensate for its liabilities.

There are quite a few different ways you can tell if a company is insolvent, but in the UK, two of the primary tests used are the balance sheet and the cash flow tests.

So, let's break each of these tests down in a little more detail in this next section:

Balance sheet test

Kicking things off, let's start with the balance sheet test, which is basically a way of indicating insolvency by evaluating whether all of your company's assets are less than its liabilities.

Now, when it comes to your company assets, you'd be taking into account both the tangible and intangible assets that you have and putting these against the outstanding debts owed by your business.

Cash flow test

Another way of finding out how financially healthy your company is can be via the cash flow test.

In essence, you're assessing your company's ability to meet all the short-term obligations you have.

If you're actually struggling to pay bills, or having difficulties in managing all of your day-to-day financial commitments, there is a strong chance that your business could be considered insolvent — given that poor cash flow tends to be a serious red flag.

Causes of company insolvency

Recognising the causes of company insolvency is vital for proactive financial management and general risk mitigation.

So, let's walk through some of the most common ways that businesses, both big and small, find themselves becoming insolvent:

Cash flow issues

If you're dealing with cash flow problems, you're probably going to struggle to cover a lot of your expenses which can lead to debt.

This issue can be exacerbated if your customers are late with payments, or you face any other kinds of unexpected expenditures like emergency costs or bills.

Outstanding debts

Racking up debts is another way your company can quickly be put in a vulnerable position, since failure to repay creditors on time tends to result in legal action causing even further financial strain.

That's why it's essential that your business has some effective practices in place regarding credit management so that you're able to avoid a situation where your debts become unmanageable.

Economic downturn

Not every reason for company insolvency is a direct result of how you've managed your business — plenty of external factors, such as an economic downturn, can have a significant impact.

Whether it's reduced consumer spending, increased competition, or any other macroeconomic factors, there are plenty of things that can contribute to a company's insolvency.

Avoiding the compulsory liquidation process

Even if external factors have caused financial pressures, there are still measures that directors and stakeholders can take in order to steer clear or reduce financial distress. They include the following tips:

Diversification and risk management

Generally speaking, managing how exposed you are to risk can mitigate a lot of the impact of economic downturns or even just specific challenges within your industry.

If you're relying on a single product or service in order to make the majority of your revenue, you're leaving your company in a vulnerable position, so make sure you diversify yourself as best as possible to lower your exposure to risk.

Timely debt management

Staying on top of your debt is an important way of avoiding it spiralling out of control — whether that's by negotiating better terms with your creditors, repaying debts on time, and generally avoiding borrowing unless you absolutely have to.

Related Guides:

What Is company insolvency: FAQs

What is a Company Voluntary Arrangement (CVA)?

How does the National Insurance Fund benefit employees during insolvency?

What Is the role of the balance sheet test in assessing insolvency?

How can a Creditors Voluntary Liquidation (CVL) benefit company directors?

What options do company directors have to address wrongful trading concerns?

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