It’s important to understand the difference between solvent and insolvent and how this affects company liquidation – if this is an avenue that business owners and shareholders opt to go down.
In its simplest form, when a business is solvent, it can meet its debt obligations (including interest). When a company can no longer cover its outgoings and outstanding debts, it will be considered insolvent.
In this post, we look at the difference between insolvency and solvency further and how a customer not paying can impact these areas.
Difference between solvent and insolvent
Solvency
In the UK, to trade legally, a business must be financially solvent.
For a business to be considered solvent, its assets must exceed its liabilities so it can continue to operate while meeting its ongoing financial obligations.
Measuring the financial health of a business is essential in understanding how likely it is that, as a creditor you will be paid; if the company is able to grow; and depending on the level of solvency, it can also indicate whether the company will be able to secure future business loans.
Often compared to liquidity, solvency is the ability to repay both short and long-term debt, plus any interest on these debts. In contrast, liquidity is the ability to repay short to mid-term debt, and this is a vital difference.
Liquidity is a quick-fire way to convert assets into cash to allow businesses to cover their immediate financial obligations.
As part of the commercial debt recovery process, we often measure a company’s solvency by the owner’s equity, i.e., company assets – liabilities = owners’ equity.
If the owner’s equity is positive, the company is deemed solvent.
Note: Businesses can also choose solvent liquidation. This is where a business owner/director will close down a financially stable business that has simply reached the end of its life. In this situation the company can pay off all its debts and close without creditors being affected.
Alternatively, insolvent liquidation is where a company can’t pay off its debts, and liquidation is mandated through a petition to the court.
Insolvency
Insolvency can be seen as a business that has no book value and will most likely close.
Insolvency can happen because of poor cash management, unforeseen financial problems, a reduction in cash flow due to late payment of invoices, an increase in company outgoings and expenses, a decline in demand, market changes, and more.
We can measure insolvency by how much liabilities exceed assets, leading to a shortfall.
Depending on the insolvency level, this can lead to insolvency proceedings and legal action taken against the business.
In these instances, company assets could be liquidated to pay off all outstanding debts.
Alternatively, the company may opt for voluntary insolvency, where directors state that the company is no longer solvent and will go into administration.
During administration proceedings, a solvency practitioner will take control of the business and the creditors the business owes will fall under the responsibility of the solvency practitioner.
Two Tests
The Insolvency Act 1986 provides two tests for measuring a company’s solvency/ insolvency, and these include:
Cash flow test – can a business afford to pay off its short–, mid-, and long-term debts? If a company can’t meet its liabilities, it is considered cash flow insolvent.
Balance sheet test – do the company’s assets outweigh their liabilities?
In order to avoid insolvency, it’s important that you manage your debt responsibly and continuously look to improve your cash flow to avoid falling into financial difficulties.
Ways to avoid insolvency
- List your debts in order of priority and look to tackle these one by one.
- Communicate and contact creditors to see if you can negotiate better payment terms.
- Is it possible to look at refinancing your debt?
- Can you consolidate your debts?
- Reduce your outgoings and overheads.
- Keep your cash flow flowing by collecting outstanding invoices and focusing on consistent cash flow.
- Avoid taking on too much debt.
- Work with a professional and experienced debt collection agency that can help you with improvements to accounts receivable processes.
- Boost your customer base.
It’s important to regularly check your business’s financial health using the two tests mentioned above to ensure companies can continue to meet their financial obligations and continue operating efficiently and effectively, meeting long-term objectives.
Debt Collection Services
As a company matures and grows, its level of solvency is expected to steadily increase and improve. However, to help this, you must have a robust credit control process in place to ensure invoices are paid on time and late payments won’t affect your cash flow.
Our team of experts can help in this area and provide valuable information and advice on a range of debt collection services.
To find out more, contact us today at +447860 197476.