A director must not allow a company to trade if they know it is insolvent. If this happens and the company is liquidated they could be disqualified. In these circumstances Directors can even made personally liable for company debts.
- How to recognize if a company is insolvent
- The commercial insolvency test
- The Balance Sheet insolvency test
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Company Insolvency – Commercial Test
Because of the risk of disqualification it is important to be able to recognise if a company is insolvent. You can then take the appropriate action to resolve the issue. If the company is eventually forced to close the risk of your conduct being questioned will be reduced.
There are two different tests which you can use to gauge whether or not your company is insolvent. The first is known as the commercial test. This is where you ask whether a company can pay its debts as and when they fall due.
If the company does not have sufficient cash to pay what it owes on time then it is technically insolvent. If cash flow problems continue and bills remain unpaid insolvency advice must be taken.
A short term cash flow issue does not mean that the company must be closed. However if the situation will be rectified with ongoing trading closure does not have to be considered. However the situation must be monitored closely.
Company Insolvency – Balance Sheet Test
The other test used to understand whether a company is insolvent is known as the Balance Sheet test. If the balance sheet shows that the company liabilities exceeds its assets it is technically insolvent.
This test is not generally used on a day to day basis. At any one point in the business cycle it is possible for a company to have greater liabilities than assets. This does not automatically mean the business should be closed.
However it is a problem if the management accounts continually show that liabilities are outweighing assets. If this situation continues with little possibility it will be rectified the company may be insolvent. An action plan must then be implemented to turn the company around.