What is Wrongful Trading

In law fraudulent and wrongful trading are two entirely different matters. It is important for any company director to understand the difference.

The Definition of Wrongful Trading

Wrongful trading is a legal concept under the Insolvency act: It is not concerned with fraud.

It is instead concerned with a directors' responsibilities towards understanding that the financial position of a business is sufficient to avoid it trading while insolvent. Ignorance is not a defence. This is best illustrated by sec. 214 (2b) of the the Insolvency act that states:

"…at some time before the commencement of the winding up of the company, that person knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation."

Note the words "...ought to have concluded".

What is Insolvency

There can be no argument that a company has become insolvent if total net assets and therefore its equity has gone into deficit. However insolvency will arrive a lot sooner than that.

If you take a look at the example of a Figurewizard balance sheet forecast you will see that net current assets are subtitled as "working capital" and with good reason.

If the total value of cash, plus cash convertible assets such as accounts receivable and stock in trade (current assets) are less than than the value of liabilities payable within one year (current liabiliities) then working capital is in deficit.

Because working capital is the source of a company's liquidity, a deficit here means that without the provision of adequate external financing (the longer the better) the company will be in very real danger of running out of cash and becoming insolvent.

That alone is why any business plan for the year or years ahead should include an accurate and credible monthly bank and cash flow forecast to include monthly available external finance. This is something Figurewizard automatically produces simply from sales, gross margin, overheads, investments and so on plus a few simple ratios, an example of which can be viewed here.

The Companies and Insolvency acts.

All lilmited companies are subject to the Companies act 2006. Directors' responsibilities under the act include their statutory duties towards protecting the best interests of the company and its members.

Crucially that changes at the point at which a company becomes insolvent. The responsibilities of directors then change from protecting its members under the Companies act to protecting its creditors under the Insolvency act.

As ignorance is not a defence, any director is well advised to plan and forecast the financial performance of the company (which is what Figurewizard makes possible) for the financial year ahead to reasonably conclude there will be no immediate risk or expectation of insolvency.

Contribution Orders under Wrongful Trading

A liquidator who is of the opinion that there is a case to answer in respect of wrongful trading can apply to a court for an order requiring individual directors of the company to make financial contributions towards the creditors of the company. 

The scale of contributions are decided by the court and depending on perceived culpability will range from the nominal to substantial. Persons who have not been appointed as directors but who are regarded by the court as having acted as such (shadow directors) can also be ordered to make contributions.

Wrongful Trading and Financing.

It is the case that a company with negative working capital can still argue that it is not insolvent if it has sufficient financing to enable it to continue to meet its liabilities.

Such financing however will have to be long term if it is to be credible. Loans that are repayable within a year must always be disregarded as their due dates make them short term financing (i.e. payable 1 year or less) which is already contributing to the insolvent position.

It should be noted that bank overdrafts are also considered to be short term financing. That is because overdrafts are repayable on demand and cannot therefore ever be regarded as long term financial arrangements.

The links below will take you to important working (interactive) examples showing hiow this can be done using Figurewizard.

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