Indicators of Insolvency Checklist
A company making ongoing losses over various periods can be used as an indication of a company heading towards insolvency; however, whilst this may be a good place to start, it is essential that it is used in conjunction with the company’s liquidity and ability to raise alternative financing from other sources in order to absorb those losses.
Liquidity ratio below 1/Negative working capital ratio
A company’s liquidity ratio measures the company’s ability to satisfy its current liabilities from its current assets. A liquidity ratio below 1 signifies that the company does not have sufficient current assets to meet its current liabilities when due and payable. A company’s liquidity ratio on its own is not a definitive indicator of insolvency and should be measured alongside the company’s access to alternative finance.
Inability to produce timely and accurate financial information
A company is under the obligation to keep financial records that accurately present a true and fair view of the company’s financial position and performance under s 286 of the Corporations Act 2001 (Cth) (the Act). A company’s failure to do so may result in a presumption of insolvency under s 588E of the Act for the period that the records have not been kept, as required.
Ongoing negative net assets
A company’s net asset position is a measure of the total assets available to meet the company’s total liabilities. An ongoing negative net asset ratio combined with the profitability of a company is a strong indicator of insolvency.
Unrecoverable loans to related parties
Significant levels of debt to related parties extending out over multiple periods with little or no repayments is a strong indicator that a business has poor cash management or may be transferring funds out of the business as a result of known insolvency.
Creditors unpaid outside trading terms
An increasing trend in payments to creditors outside trading terms suggests the company may be having difficulty meeting its liabilities when due and payable. However, it should be investigated whether the company had inadequate funds to meet those payables or whether it was a trend the company routinely followed out of habit.
Solicitors’ letters, demands, summonses, judgements or warrants against the company
Situations where the company has received multiple demands for payment, letters warning stop supply and/or statutory demands from creditors implies solvency issues as it indicates the creditors’ increasing concerns regarding the company’s future ability to pay. A presumption of insolvency can be applied where this is happening on an ongoing basis and creditors are threatening to file in court against the company.
Suppliers placing the company on cash-on-delivery (COD) terms
In situations where companies are not paying their creditors on time, a creditor may apply such terms where they demand payment to be made upon delivery of goods to ensure payment. This arrangement indicates a creditors’ concern over a company’s future and current ability to pay and hence applies special terms before commencing supply to ensure payment for all invoices are collected.
Dishonored and post-dated cheques
These represent cheques that have been dishonoured generally because there are not sufficient funds available in the company’s bank account at the time the cheque is presented. If a company is consistently issuing dishonoured cheques to creditors, this could be an indication of cash flow issues and company solvency should be investigated.
Special arrangements with selected creditors
Sometimes creditors agree to make special arrangements with a debtor in order to avoid legal fees and continue supplying goods to the company (such as a payment plan). Entering into such an arrangement suggests that the company is having difficulty meeting its debts and entering into such arrangements on an ongoing basis or defaulting on repayment arrangements can be a strong indicator of insolvency.
Payments to creditors of rounded sums not reconcilable to specific invoices
Payments to creditors of rounded sums is typical of a company that is unable to pay its invoices when due and cannot negotiate a repayment arrangement causing it to extend out its payments through part-payment of invoices in round sums that is irreconcilable to specific invoices. If this is a recurring occurrence then it may imply the company is using small amounts of cash to pay large debts and may be insolvent.
Inability to obtain finance from bank, related parties or shareholders
A poor relationship with its bank due to a history of loan defaults or dishonoured cheques could result in a company unable to obtain financing. In addition, an inability to obtain financing from alternative sources such as related parties or a reluctance by shareholders or investors to inject funds into a business indicates that they may not feel the business is profitable or has prospects of success. Although these do not prove insolvency, they provide a warning that the business may be turning insolvent.
Overdue commonwealth and state taxes
A history of overdue commonwealth and state taxes is a common way many companies survive as a business and maintain cash-flow. An investigation into the company’s outstanding taxes can illustrate any ongoing occurrences and if so, can be a good indicator of insolvency.