Definitions of Insolvency

Liabilities exceeding assets defines balance sheet insolvency. Running out of cash defines cash flow insolvency regardless of profits.


When planning a business, the most important forecast (one of the many that Figurewizard produces) is the balance sheet and the most important number in that will be for net current assets; broadly defining liquidity. 

In effect this forecast tells you whether or not your business is forecasting insolvency. If that were to happen, directors would not necessarily walk away from the wreckage scot-free as what follows explains.

Wrongful Trading

A company going into insolvent liquidation will come under the aegis of the insolvency act 1986, section 214 of which is concerned with wrongful trading.

Ignorance is not a defence as the test of knowing that a company is heading towards insolvency is that either the directors knew that the company was insolvent or (much more dangerously) "ought to have concluded" that it was likely to become so while continuing to trade and accept credit.

A director held to have wrongfully traded can become personally responsible for part or in extreme cases all of the debts of an insolvent company, secured or otherwise. This can apply from the time that the court concludes the directors ought to have known that they were trading insolvently.

Balance Sheet Insolvency

If net assets are in deficit so is equity and that defines balance sheet insolvency. All liabilities including contingent and prospective (long term) are included when calculating balance sheet solvency or otherwise.

A balance sheet deficit is not the only definition of insolvency though. Unlike cash convertible current assets, fixed assets make no contribution to working capital, liquidity or cash flow. What really matters in a balance sheet is the value of net current assets.

Cash Flow Insolvency

In the real business world insolvency has nothing to do with profits and everything to do with cash. Net current assets or working capital is what describes the liquidity that will be expected to generate that cash.

If your Figurewizard forecasts shows this in deficit it will be time to go to the What-If Caculator and Planner and change your budgeted figures for overheads, year end stock, investment or financing in the business plan until it is positive.

Fixed Assets are Illiquid

Fixed assets are not readily cash convertible which is why their values play no part when calculating liquidity.

Their costs however, including all of those engaged in their financing do play a crucial part in calculating liquidity by being charged to it - Yet another reason why comprehensive forecasting needs to go hand in hand with planning.

Avoiding Insolvency

If you wait for the year end accounts to reveal that your net assets or working capital are heading towards insolvency, it may already be too late.

A business plan with detailed forecasts, especially for working capital and cash flows, that can be easily updated as the year progresses is the key to planning to avoid such problems before they arise, which is exactly what makes possible for you

. To see how this we do this, follow one or more of the links below. Taking a look at the What-If calculator and planner is especially recommended.

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