Last editedNov 20222 min read
A company is insolvent when it can’t pay its debts. Yet there are two forms of insolvency to be aware of for UK businesses: cash flow insolvency and accounting insolvency. These describe the two methods used to test a company’s solvency via the balance sheet or cash flow statement. Here’s a closer look at cash flow insolvency vs accounting insolvency.
What is cash flow insolvency?
The cash flow insolvency definition is when a company cannot meet its financial obligations when they’re due. A company might have sufficient assets in the form of investments and property. Yet if these aren’t liquid, they can’t be used to meet short-term obligations. Assets take time to sell or otherwise convert into cash. A company that’s asset rich and cash poor would then be cash flow insolvent. Unlike accounting insolvency, this test focuses purely on cash flow.
What is accounting insolvency?
Also called balance sheet insolvency or technical insolvency, accounting insolvency occurs when a company’s liabilities outweigh its assets. This is a more long-term, and usually serious, problem for businesses to solve. Liabilities can grow at a faster rate than assets due to interest fees, increased debt, and more borrowing. At the same time, assets often depreciate. When total liabilities are higher in value than total assets, it means the company has a negative net worth and is therefore insolvent on the books. At this stage the company could face bankruptcy or restructuring.
Key differences between cash flow insolvency and balance sheet insolvency
Both cash flow and balance sheet insolvency tests are important to assess a company’s financial health. There are a couple of key differences between the pair:
Balance sheet insolvency compares assets and liabilities. Cash flow insolvency compares available cash flow to meet outgoings on time.
Balance sheet insolvency takes a long-term view, while cash flow insolvency looks at shorter term obligations.
Cash flow insolvency is an easier problem to solve through negotiation, while balance sheet insolvency is a more serious issue.
Most companies that are balance sheet insolvent will also be cash flow insolvent, but the reverse situation isn’t always so clear.
It’s also helpful to take a closer look at the specific tests for insolvency to understand these differences. If creditors accuse your company of accounting insolvency, the court will first look at your existing balance sheet liabilities. Prospective or future liabilities will also be considered as part of this test, such as legal decisions and deferred payments.
By contrast, a cash flow test for insolvency ignores assets and simply looks at incoming streams of income to determine whether the company can pay its bills on time. However, this test is more speculative than the accounting test which is based purely on balance sheet figures.
How to prevent cash flow and balance sheet insolvency
Cash flow insolvency is easier to correct than balance sheet insolvency. It’s often caused by a lag in the billing cycle. If customer invoices aren’t paid in sufficient time to settle accounts with your own suppliers, you’ll struggle to pay bills on time. You can help prevent this by adjusting payment terms to a shorter time frame. Automating the invoicing process also helps with on-time payment collection. GoCardless can help reduce payment failures, late payments, and all associated admin with our Direct Debit and Instant Bank Pay solutions. Businesses retain control over the timings of payments, helping improve cash flow.
While there is always inherent risk in business, you can also reduce your chances of insolvency by keeping a close eye on finances with regular forecasting. Negotiate payment terms with your own creditors to ensure you keep on top of your liabilities over time. With frequent communication and efficient accounting systems, you can spot any signs of trouble in time to correct them.
We can help
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