Indicators of Insolvency

Continuing Losses

Not every business that makes a loss, or a series of losses, is insolvent. When working capital is available to meet losses, insolvency can be avoided. Losses alone do not cause insolvency. Rather, insolvency is usually a combination of losses, and insufficient working capital.

Solely concentrating on losses without considering the company’s/business’s capacity to absorb those losses may not give a true picture of the solvency position. However, if the loss is significant enough, or over a long enough period, the ability of the company to absorb those losses is eliminated.

Liquidity Ratio Below One

Liquidity measures the extent to which liquid assets are available to cover payable debts. A business liquidity ratio compares its current assets and current liabilities. If the ratio is greater than one, this means there is more liquid assets than payable debts and indicates the business should be able to pay debts from its available assets. If the ratio is less than one, the converse principle applies.

While the liquidity ratio provides a pointer to solvency, it is not a conclusive indicator. A liquidity ratio measures available assets at a specific time and does not factor in the dynamics of cash-flow or whether a debt is actually payable at that time. Some other factors that need to be considered is that the ratio usually uses funds in the bank, rather than allowing for possible borrowed funds and available overdraft facilities also need to be considered. Further, a liquidity ratio does not allow for whether some assets (such as stock and receivables) are truly liquid. Business owners should examine the reasons for a liquidity ratio below one, and decide whether action is needed.

Overdue Commonwealth and State Taxes

Many businesses regard the non-payment of taxes as the easiest way to save cash-flow and survive. This is commonly referred to as ‘borrowing the money from the government’. The rationale is that unlike general lending terms there are no application forms, no valuations, and no bank fees. In addition, there is no recourse of non supply or repossession, and the application of interest can be delayed or negotiated.

Non-payment of tax commitments (GST or PAYG withholding) is a good indicator of insolvency. In most cases businesses that do not pay tax, cannot pay tax. Business owners should consider whether they are insolvent when taxes remain unpaid.

Poor Relationship With Present Bank Including Inability to Borrow Further Funds

Banks have a distinct advantage over other creditors. Banks know what funds are available and can analyse the flow of funds through a business account. If the business borrowed money from the bank, the business owners regularly provide the bank with financial information. Usually, none of this information is available to other creditors. A poor relationship with a bank usually stems from:

The non-repayment of monies due;
The bank regularly dishonouring cheques; and
The bank’s assessment of the financial position, or management of the business.

A poor relationship with a bank does not prove that the business is insolvent, just as a good relationship is not proof of solvency. The bank may also be unaware of a business’s insolvency, because the business has operated within the bank’s agreed limits, while not paying other creditors.

The bank’s lack of confidence in the business and its solvency can create a poor relationship. Certainly, if a bank refuses to advance further funds or calls up a loan or overdraft, its reason must be clear. If a bank refuses further funding it may, and often does, cause insolvency.

No Access to Alternative Finance

Typically, two finance solutions are available to businesses in need of capital:

The debtor can convert short-term debt to long-term debt, which can be repaid on a certain date, or intermittently, over a period. If a debt is no longer ‘due and payable’ it will not form part of a strict solvency calculation; and
Businesses may borrow funds to pay due debts. This creates a new debt to pay an old debt.

Care must be taken not to mislead the lender, even if the loan is to satisfy the current debt and alleviate a current cashflow problem. If the business later fails, the new loan may have personal liability consequences for the business owner.

Inability to Raise Further Equity Capital

An equity investor can inject funds into the business. Investors seek an eventual return from profits, and do not compete with the repayment priority of debts. Diligent equity investors will review the business finances and prospects to be satisfied that the return is commensurate with the risk. An inability to use these finance solutions is a strong indicator that a business has a cashflow problem and is possibly insolvent. If business owners cannot get funding to pay outstanding debts, they should suspect insolvency.

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