Test for Insolvency

A company is insolvent under section 95A of the Corporations Act 2001 (the ‘Corporations Act’) if it is unable to pay its debts as and when they fall due.

This is a question of fact to be considered on a case by case basis.

There are two tests for insolvency.

Firstly, the balance sheet test.

The balance sheet test is that a company will be insolvent if liabilities exceed assets- in other words the liabilities of the company would not be met if all the assets of the company were liquidated and used to meet those liabilities. This test is difficult to apply when there is not an obvious market for assets of the debtor, and/or a value cannot easily be ascribed to those assets.

Finally, the cash flow test.

This is the preferred test and is, in effective, enshrined in section 95A of the Corporations Act above.

The cash flow test holds that the extent to which assets exceed liability is irrelevant. The basis is that the company is technically insolvent if it cannot meet its day to day commitments, and creditors should not be forced to wait while the debtor realises some of its assets to pay them, particularly if those assets cannot be easily liquidated. The view taken by the court is that (Southern Cross Interiors Pty Ltd v DCT(2001) 39 ACR 305):

“in considering the company’s financial position as a whole, the Court must have regard to commercial realities. Commercial realities will be relevant in considering what resources are available to the company to meet its liabilities as they fall due, whether resources other than cash are realisable by sale or borrowing upon security, and when such realisations are achievable.”

What Indicates Insolvency

ASIC v Plymin (No. 1)(2003) 46 ACSR 126 gives some considerations that may indicate insolvency in the context of director liability for insolvent trading:

1. Continuing losses.

2. Liquidity ratios under 1.

3. Overdue taxes.

4. Poor relationship with a bank resulting in inability to borrow further.

5. No access to alternative finance.

6. No ability to raise more capital.

7. Suppliers only providing goods ‘cash on delivery’.

8. Creditors unpaid outside trading terms.

9. Issuing post-dated cheques.

10. Dishonoured cheques.

11. Special arrangements for selected creditors.

12. Judgments, solicitors letters and similar issued against the company.

13. Payments to creditors of rounded amounts rather than payments of specific invoices.

14. Inability to produce timely and accurate financial statements.