The term' insolvency' is ubiquitous in the commercial world, but what does it actually mean? And how does one know that a business is insolvent? The answer to the first question is thus: insolvency occurs when a person or business cannot pay its debts when they are due. This article is concerned with the second question. There are two ways to determine whether a company is insolvent: a) identifying whether the organisation is balance sheet insolvent, or b) cash flow insolvent. To gain a comprehensive insight into each of these tests, keep reading.
Summary
- A company’s solvency is assessed using the cash flow test (can it pay debts as they fall due?) and the balance sheet test (do liabilities exceed assets?). Failing either indicates insolvency under the Insolvency Act 1986.
- Cash flow insolvency occurs when a company cannot meet short-term debts despite having sufficient assets on paper. Persistent missed payments, bounced cheques, or creditor threats are early red flags.
- Balance sheet insolvency happens when total liabilities exceed the fair value of assets. It reflects long-term financial weakness and often precedes administration or liquidation.
- These tests trigger directors’ duties to act in creditors’ interests, avoid wrongful trading, and seek insolvency advice. Courts use them in winding-up petitions and insolvency proceedings.
- If either test suggests insolvency, directors must document decisions, stop taking new credit, and seek immediate professional advice to protect creditors and minimise personal liability.
What is Cash Flow Insolvency?
Cash flow insolvency is the more easily recognised insolvency test – it occurs when the company does not have enough cash to pay its invoices and loans. On paper, the business may seem fine, i.e., it has valuable assets, but the company is poor in terms of cold, hard cash.
What is Balance Sheet Insolvency?
Balance sheet insolvency is where an organisation's liabilities outweigh its assets. Liabilities include all debts, payments and money owed to creditors, ranging from utility bills and mortgages to wages, pension payments and taxes. Assets will consist of everything with capital value, including vehicles, property, equipment, hardware, trademarks, machinery, and computers.
What is The Balance Sheet Insolvency Test?
To conduct a balance sheet insolvency test, you must measure all the company's current assets against its debts, including contingent and prospective liabilities. Section 132 (2) of the Insolvency Act 1986 provides that a company is technically insolvent if there are more liabilities than assets.
The balance sheet insolvency method is a more straightforward test than cash flow insolvency. This is because the latter can be used to identify if a company cannot pay its debts as they fall due or in the 'reasonably near future', meaning the date of possible insolvency is vague. With the balance sheet test, an organisation knows its immediate financial position and can plan to rescue the business by, for example, proposing a CVA or voluntary administration.
Why are the Company's Liabilities Greater Than Its Assets?
Events such as a fall in property values or directors paying themselves too much money can cause the value of a company's assets to fall below the amount of its liabilities. Overstating the value of assets on the balance sheet is also a common error.
What is The Cash Flow Insolvency Test?
The cash flow insolvency test measures a company's liabilities against the cash it has in the bank. Under section 123(1)(e) of the Insolvency Act 1986, a company is deemed unable to pay its debts if it cannot discharge them as they become due. The courts interpret this not as a snapshot of the company’s immediate bank balance, but as an assessment of its short- to medium-term liquidity. Future debts that are imminent or reasonably foreseeable are also considered, especially if the company’s financial position shows no realistic prospect of improvement. This test is less accurate than the balance sheet insolvency test, as the company's assets may outweigh its debts, but the business cannot liquidate those assets fast enough to meet creditor payment terms.
For directors, failing the cash flow test is a warning sign of potential insolvency. It triggers duties to act in the interests of creditors and consider steps such as restructuring or administration. Regular cash flow forecasting and early intervention are essential to avoid breaching these duties and worsening creditor losses.
Businesses that fail the cash flow insolvency test risk being issued a Winding Up Petition (WUP). A WUP is a legal process a creditor can take if a company owes them £750 or more. The petition is issued in Court and served at the company's registered office.
If, at a hearing, the Court agrees that the company is insolvent because it cannot pay its debts, a liquidator will be appointed. However, issuing a WUP is highly risky on the creditor's part, as they may be made liable for legal costs and/or have a counter-claim brought against them.
Cash Flow Test vs Balance Sheet Test
| Test type | Cash Flow Test | Balance Sheet Test |
| Definition | Assesses whether a company can pay its debts as they fall due. | Examines whether the company’s liabilities exceed its assets. |
| Legal Basis | Section 123(1)(e) of the Insolvency Act 1986. | Section 123(2) of the Insolvency Act 1986. |
| Indicators | Missed or late payments, creditor threats, bounced cheques, and inability to meet payroll or HMRC obligations. | Consistent negative net assets, overdrawn directors’ loan accounts, and contingent liabilities such as guarantees or pending claims. |
| Practical Impact | Failure suggests the company is unable to meet short-term obligations, triggering potential insolvency duties and creditor action. | Failure indicates long-term financial imbalance, prompting directors to seek insolvency advice or consider restructuring or liquidation. |
What Must Directors Do If They Suspect Their Company Is Insolvent or About to Become So?
If directors suspect their company is insolvent or close to becoming insolvent, they must shift their focus from shareholders to creditors. Under the Companies Act 2006, particularly section 172(3), the duty to promote the success of the company becomes subordinate to protecting the interests of creditors. Directors must act with honesty, diligence, and reasonable care, taking all steps to minimise potential losses.
They should immediately assess the company’s financial position, seek professional insolvency advice, and avoid actions that could worsen debts or unfairly favour certain creditors. Continuing to trade while knowing the company cannot meet its obligations risks liability for wrongful trading under section 214 of the Insolvency Act 1986.
In practice, directors should document decisions carefully, stop taking on new credit if repayment is uncertain, and explore restructuring or formal insolvency procedures. Acting promptly demonstrates compliance and helps protect directors from personal liability.
How Have the Courts Defined The Balance Sheet Insolvency Test in the Eurosail Case?
In BNY Corporate Trustee Services Limited v Eurosail, the Supreme Court confirmed the balance sheet insolvency test under Section 123(2) of the Insolvency Act 1986.
Background
This case came out of the 2008 financial crisis. Eurosail acquired a portfolio of subprime mortgage loans, secured on UK residential properties, funded by the issue of several classes of loan notes. The conditions of the loan note issue stated what constituted default, incorporating the Insolvency Act 1986 section 123(1) and section 123(2).
Following the collapse of the Lehman Brothers group, with which Eurosail had currency and interest-rate hedging arrangements, and the detrimental changes in both interest and currency rates, together with the poor performance of the domestic mortgage market, Eurosail's audited accounts showed liabilities substantially higher than assets. Although the value of sterling had depreciated against both the euro and the dollar, the low interest rates resulted in a surplus, enabling Eurosail to pay the interest on all the outstanding notes fully. Accounting rules required the use of current spot exchange rates despite the redemption date not being until 2045. To obtain payment priority, a class of noteholders relied on the liabilities in the audited accounts to assert that Eurosail was deemed unable to pay its debts within the meaning of section 123(2).
Decision
The Supreme Court rejected the Court of Appeal's ruling that a company could be deemed insolvent only after it reached "the point of no return". Instead, the actual test should be whether, on the balance of probabilities, the debtor has insufficient assets to meet all of its liabilities, applying a discount for contingencies and future liabilities. The balance sheet test should be used once an attempt to apply a cash-flow test becomes too uncertain due to the time period lengthening beyond the near future. But the Court concluded that it was "still very far from an exact test", and the party trying to prove balance-sheet insolvency would always have the burden of proving the test.
What Does The ‘Eurosail’ Case Mean in Practice?
The ‘Eurosail’ decision confirmed the balance sheet test. It also determined:
- The cash flow test should only consider the 'near future' in terms of what is reasonable given the current circumstances.
- A company does not have to reach the point of no return before it can be declared insolvent; however, the Court should not be in a rush to make such a determination.
- The financial statements are only the starting point when determining balance sheet insolvency. All assets and liabilities must be considered. In addition, some liabilities can carry more weight than others; for example, a lower value should be apportioned to liabilities that are slow to mature.
How Can Company Directors Spot Potential Insolvency?
Directors should remain alert to early signs that a company may be insolvent. Under the cash flow test, warning signs include missed payments, creditor threats, and declined card payments, all suggesting the business cannot meet debts as they fall due. Under the balance sheet test, red flags include negative net assets, overdrawn directors’ loan accounts, and contingent liabilities such as personal guarantees. These indicators show that liabilities may outweigh assets, putting the company at risk. Directors must act quickly, seek professional advice, and avoid taking on further debt once insolvency appears likely to minimise personal and corporate exposure.
Why Do The Cash Flow and Balance Sheet Tests Matter for Company Directors?
The cash flow test and balance sheet test are vital tools for directors in assessing a company’s financial health and legal position. These tests help identify when a company has moved from short-term financial difficulty to actual insolvency, which is the trigger point for the switching of directors' duties from growing and promoting the company to taking actions that are in the best interests of the company’s creditors. Once insolvency is likely, directors must also avoid actions that could amount to wrongful trading, such as taking on new debts the company cannot repay.
The results of these tests also determine whether the business can continue to trade or must seek immediate insolvency advice. Regular monitoring helps directors make informed decisions about restructuring, refinancing, or voluntary liquidation before the situation worsens.
In legal proceedings, courts rely on the cash flow and balance sheet tests to decide whether a company is insolvent for winding-up petitions, administration applications, and other insolvency processes.
How to Apply the Cash Flow Test
- List all short-term liabilities due now and in the next 12 weeks, including suppliers, payroll, rent, and HMRC.
- Identify immediate assets and inflows: cash at bank, undrawn facilities, and confirmed customer receipts.
- Prepare a weekly cash flow showing opening cash, receipts, and payments.
- Include realities: likely receipt dates, VAT and PAYE deadlines, and any bounced or returned items.
- Stress test for slippage in receipts and unexpected costs.
- If you cannot meet debts as they fall due, the cash flow test fails..
How to Apply the Balance Sheet Test
- Start with the latest management accounts and adjust to fair value where needed.
- Review and impair assets that are overstated, such as slow-moving stock or doubtful debts.
- Add contingent and prospective liabilities: guarantees, litigation, dilapidations, redundancy costs, and contractual penalties.
- Include accrued interest, overdue taxes, and any director loan balances owed by the company.
- Compare total adjusted liabilities to total adjusted assets.
- If liabilities exceed assets on a real-world basis, the balance sheet test is failed.
Directors’ Checklist: If Either Test Indicates Insolvency
- Hold an urgent board meeting and make minute decisions.
- Prioritise creditors’ interests and avoid incurring new credit you cannot repay.
- Stop payments that could be preferences or transactions at an undervalue.
- Tighten cash control and stop non-essential spending.
- Seek advice from an insolvency practitioner and legal counsel immediately.
- Keep full records, communicate factually with key creditors, and consider options such as a time to pay, CVA, administration, or liquidation.
What You Can Do if Your Company Is Insolvent?
If you are worried your company is insolvent, the Insolvency team at Witan Solicitors can advise and represent you. Several options are available to you, including exploring voluntary administration or liquidation or proposing a CVA to your creditors.
As experts in insolvency law, Witan Solicitors can provide expert advice and representation if you are being investigated for wrongful or fraudulent trading. Contact us on 0330 173 6983 or send us an email for more information.
FAQ
What is the difference between the cash flow test and the balance sheet test?
The cash flow test assesses whether a company can pay its debts as they fall due, while the balance sheet test examines whether liabilities exceed assets. Failing either test suggests insolvency and triggers directors’ duties to act in creditors’ best interests and seek professional advice.
What is cash flow insolvency?
Cash flow insolvency occurs when a company cannot pay its debts on time, even if its assets exceed its liabilities. It means the business lacks sufficient cash or liquid assets to meet immediate obligations such as payroll, suppliers, rent, or HMRC payments.
What is balance sheet insolvency?
Balance sheet insolvency arises when a company’s total liabilities exceed the fair value of its assets. Even if it can pay its bills temporarily, the underlying financial position is unsustainable. This test focuses on long-term solvency and overall financial stability.
What happens if a company is cash flow insolvent but not balance sheet insolvent?
A company may still operate for a short time if it has sufficient assets but limited liquidity. However, persistent cash flow insolvency is a warning sign that insolvency proceedings may follow if debts remain unpaid. Directors must act quickly and seek insolvency advice.
How do directors know if their company is insolvent?
Directors can determine insolvency by applying the cash flow and balance sheet tests. Signs include missed payments, negative net assets, and creditor pressure. If either test indicates insolvency, directors must stop trading on credit, document decisions carefully, and seek immediate professional advice.
