Insolvency is a critical issue that can have profound financial and legal implications for both businesses and individuals.
The Insolvency Act, 1986 refers to two tests which can be relied upon when assessing whether a company may be insolvent.
- The ‘Balance Sheet Test’ is straightforward; if a company’s liabilities are greater than its assets then it is insolvent.
- The ‘Cashflow Test’ on the other hand, says that a company is insolvent if it is unable to pay its debts as and when they fall due.
The first is quite straightforward, the second less so, but if you have a client that falls into either category, they are technically in an insolvent position.
Directors must be mindful of their duties at these times and are expected to seek advice where required.
In this blog, we will explore five essential aspects that accountants need to consider when evaluating a client’s solvency or potential insolvency.
1. Cash Flow Management
Cash flow management is the cornerstone of financial stability. When you notice consistent negative cash flow or irregularities in cash flow patterns, it can be a red flag indicating financial distress.
Bottlenecks in cash flow, delays in receiving payments, or excessive expenditure can all pave the way toward an insolvent situation, if not managed correctly. By proactively addressing these issues, accountants can help their clients make informed financial decisions and avoid the pitfalls of insolvency.
2. Debt and Liabilities Analysis
Understanding a client’s debt and liabilities is essential for assessing insolvency risk accurately.
Regularly reviewing your client’s balance sheet to identify the extent of their debts, including loans, credit lines, and outstanding bills as well as being aware of any upcoming financial obligations, such as loan maturity dates or tax payments can all help.
In addition, a high debt-to-equity ratio may indicate that a client is highly leveraged and at greater risk of insolvency, especially if they struggle to meet interest payments or principal repayments.
3. Profitability and Income Assessment
Of course, we cannot ignore a client’s profitability and income streams. This is a good indicator of the health of both your client’s business and personal finances.
A decline in profitability, recurring losses, or an inability to generate consistent income can all be warning signs of insolvency.
Considering factors like market trends, competition, and economic conditions that may impact a client’s ability to maintain or increase their income is also recommended.
By identifying these issues early on, you know you can work with your clients to implement strategies to improve profitability and financial stability over time.
4. Directors Loan Accounts
Often shareholder/directors choose to take their drawings as a mix of salary and dividend payments.
However, if there are insufficient reserves to declare dividends against, then the drawings become classified as directors’ loans (amounts which are repayable to the company).
This should act as a key indicator that the company is not performing as well as expected. If a company is not making sufficient profit to cover the directors’ drawings, they ought to pause to consider the general health of the company.
5. Legal and Regulatory Compliance
Insolvency is a complex and multifaceted issue that, as your client’s advisor, you must be aware of.
We can assist accountants by providing specialist support to them or their clients, advising them on their rights and responsibilities when facing insolvency and help them navigate the legal complexities.
Additionally, understanding the potential consequences of insolvency, such as creditor lawsuits or asset seizures, is crucial for developing effective strategies to mitigate these risks.
By paying close attention to cash flow management, debt analysis and profitability, accountants can help their clients make informed decisions to avoid insolvency or effectively navigate the insolvency process when necessary.
At BABR we can assist by giving recommendations on the best options available and provide advice and guidance to help clients make informed decisions and ensure they are aware of any potential risks.
If you would like to talk through the options that might be available for any of your clients, then don’t hesitate to contact the insolvency team at BABR for an informal discussion.