CORPORATE
GOVERNANCE TRAINING
MODULE 12: INSOLVENCY
TESTS
ADB Private Sector Development Initiative
Corporate and Financial Governance Training
Solomon Islands
Originally by
Dr Judy Taylor
Acknowledgments
2
These materials were produced by Dr Judy Taylor from La Trobe University, through the Asian Development
Bank’s Pacific Private Sector Development Initiative (PSDI). PSDI is a regional technical assistance facility cofinanced by the Asian Development Bank, Australian Aid and the New Zealand Aid Programme.
Outline of session:
3
What is insolvency?
How do I test for insolvency?
Early warning signs of insolvency.
What is insolvency?

There are two definitions of insolvency.
 Cash
flow insolvency
 Balance sheet insolvency


Cash flow insolvency occurs if the company is
unable to pay their financial obligations as they fall
due in the normal course of business.
Balance sheet insolvency, also referred to as
technical insolvency, occurs if the Liabilities are
greater than the Assets.
Insolvency defined
A company can be cash flow insolvent but balance
sheet solvent
 They can’t pay their bills on time but they have
more assets than liabilities
Or
 A company can be balance sheet insolvent but cash
flow solvent (often due to high levels of debt)

Applying the test for insolvency
Cash flow
Balance sheet
Outcome
Insolvent
Solvent (A>L)
Stop trading,
Call meeting
review business, raise
capital or sell parts of
business
Insolvent
Insolvent (A<L)
Stop trading
Call meeting appoint
liquidator
Solvent
Insolvent (A<L)
? (high levels of debt)
Call meeting
Raise equity
Testing for Insolvency-Cash Flow

Cash Flow test
 If
a company has defaulted on its obligations, the
company’s ability to pay its debts under normal
circumstances of the company need to be appraised.
 The test is not perfect or precise
 Here the company focuses on the ratio of current
assets(CA) to current liabilities (CL)
 CA/CL must be greater than 1
 The company in the normal course within a year, has
more current assets than current liabilities.
Testing for Insolvency-Cash Flow
Temporary financial difficulties may not automatically deem
a company insolvent if they have greater resources to draw
on.
 If CA/CL less than 1 and the company has no further
resources to draw on it is insolvent. It cannot meet its
obligations
 If they have resources to draw on, such as raising capital,
selling long term assets subject to total Assets remaining
greater than Liabilities, they may not be insolvent. Amount
of time to restructure becomes important and incurring new
creditors during this period may be problematic.

Testing for Insolvency

Balance Sheet test
If total assets are less than total liabilities and the
company is meeting its cash flow obligations the test is
whether the company can
 Gather additional funds quickly, usually equity, or sell
parts of the company, and
 Pay debts without affecting the underlying structure of
company
Insolvency versus going concern


Cash flow insolvency sees insolvency as a day to day issue
Balance Sheet insolvency is seen when the Financial
statements are constructed 6 monthly or annually when the
company, and auditor, needs to evaluate whether the
company is a going concern

Can they meet their obligations over the next 12 months?
Early warning signs of insolvency


Red flags in analysis module identify many of the early
warning signs of insolvency.
Early warning signs of insolvency can be grouped in
two categories
What will management see
 What will the Directors see



Management will often see the early warning signs
before Directors
This reinforces the need for strong internal systems,
reporting channels and a healthy ethical environment
that allows staff to bring forward problems in a non
threatening manner
Early warning signs of insolvency

Management
 Problems
selling stock
 Problems collecting funds
 Slow payment of debts outside usual business terms
 Solicitors letters
 Issuing post dated cheques
 Suppliers insisting on cash-on-delivery terms
 Payments to creditors of rounded sums not reconcilable
to specific invoices.
Early warning signs of insolvency

Directors
 Poor
cash flow compared to income
 Ongoing losses
 Failure to develop business plan
 Failure to budget or review expenditure regularly
 Failure to forecast cash flow
 Overdraft limits reached
 Converting overdraft into fixed debt
 Changing banks, more stringent lending conditions,
higher margins
 Board disputes resignations
Early warning signs of insolvency





Proper reporting by management of the early warning
signs to the board is essential
The board must determine appropriate reporting so
that early warning signs will be reported on.
Reporting should include the early signs seen by
management and employees
Otherwise, once the board sees the early warning signs
the company is much closer to insolvency.
Early warning signs can become questions and reports
required by Directors to avoid insolvency and to alert
them to insolvency issues as early as possible.