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Most directors should be aware that they may be made personally liable for any unpaid debt their company incurs while it is insolvent.
In February’s newsletter, we gave an introduction to insolvency as well as some tips on how to avoid it.
(Catch up on the February edition- Insolvency: What it is and how to avoid it?)
This month, we delve further into what insolvency really means and when a liquidator or the Australian Securities and Investment Commission will be able to establish in court that a company was insolvent. This newsletter will look closer at the definition of insolvency, and some things to keep an eye out for to determine if a company is trading while it is insolvent.
Definition of insolvency
Section 95A of the Corporations Act 2001 defines solvency and insolvency as follows:
- 95A(1): A person is solvent if, and only if, the person is able to pay all the person’s debts, as and when they become due and payable.
- 95A(2): A person who is not solvent is insolvent.
Simply put, a company which is unable to pay all its debts as, and when, they become due and payable is insolvent.
Insolvency indicators
In practice however, the Courts have applied various tests of indicators that a company was insolvent.
Although no indicator is necessarily conclusive, the more indicators which are present the more likely the Court will determine a company was insolvent.
The indicators of insolvency include:
1. A balance sheet with:
- A poor, negative or deteriorating net asset position
- Inadequate or deteriorating working capital, as indicated by a current ratio (the ratio of current assets to current liabilities ) or a quick ratio less than 1:1
- Debtors and creditors unpaid outside trading terms (commonly 30 days)
- Increasing ageing of accounts payable and receivable
- Poor or deteriorating levels of cash over time
- Payments to creditors of rounded sums not reconcilable to specific invoices
2. A profit and loss statement with:
- A history of unprofitable trading, especially accumulating trading losses
- Deteriorating gross margins over time
3. Other information or material that may demonstrate:
- Poor or inadequate books and records
- An inability to raise debt or equity finance, including a poor relationship with the current banker (especially an inability to borrow further funds)
- Increasing level of loans from third parties to support working capital
- Failure to pay statutory liabilities (eg superannuation, PAYG withholding, GST, other taxes)
- Failure to pay insurance premiums
- Proceedings commenced to recover debts owed by the company (letters from solicitors, court proceedings and statutory demands)
- Any admissions of financial difficulties or inability to pay
- A change in trading terms, especially a restriction to cash on demand or creditors demanding special payments before resuming supply
- Special repayment and deferment arrangements with selected creditor
- An overdraft facility regularly at or exceeding its limit
- Cheques being dishonoured
- Cheques being drawn but not mailed to creditors
- Post-dated cheques being issued
Directors and their advisors should be aware that the definition of insolvency considers more than just the balance sheet position of a company, and should their company be exhibiting more than one of the abovementioned indicators of insolvency, take appropriate action in order to minimise the risk of an insolvent trading claim
1Cash and other assets that are expected to be converted to cash within a year
2Amounts due to be paid to creditors within twelve months
3(Current assets - inventory)/ (current liabilities - bank overdraft)
4(Revenue - cost of goods sold)/ (revenue)
Get in touch with a RSM debt solutions specialist.
RSM’s Restructuring & Recovery has registered bankruptcy trustees who can advise on personal insolvency. Please get in contact with your local office today.
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