What is Insolvency in Business Terms? A Simple Guide

Companies of all sizes face financial challenges that can lead to insolvency. But what is insolvency in business terms?

In the simplest terms, a business being insolvent means that it’s unable to meet its financial obligations. These could be supplier invoices, utility bills, or anything it needs to pay.

Of course, there are some nuances to that though, and understanding what insolvency entails and the options available can be crucial in navigating these turbulent waters.

So, what is insolvency in business terms, and how can you avoid it?

 

 

What is insolvency in business terms?

Insolvency is basically the business equivalent of being bankrupt or ‘bust’. An insolvent company may still have money and assets, but not enough to cover all of its outgoings.

This doesn’t necessarily mean that the company has been managed in an irresponsible manner though. Insolvency can be a very real threat for most businesses, and without taking appropriate steps to avoid it, it can be easy to fall into.

For example, it may just be the fact that being paid for completed jobs is taking longer than your business has to pay its bills.

While insolvency can be used as a loose catch-all term to describe a business that can’t pay all of its debts, this doesn’t completely answer the question of ‘what is insolvency in business terms’. For that, we need to take a look at the three main tests used to determine whether a company is insolvent:

 

Cash flow test

This looks at a company’s ability to pay its debts when they’re due. Even if it can pay its debts, but the payment is a little late, it can still suggest insolvency.

 

Balance sheet test

This looks at the assets and liabilities that the business holds. A company will soon run into trouble if its liabilities outweigh its assets, even by the smallest amount. If this is found to be the case, the business is found to be insolvent.

 

Legal test

A business can also be considered insolvent sometimes if it has legal action taken against it. Winding up petitions and county court judgements are two such legal measures that could render a company insolvent.

 

These three tests make up the pillars of what is insolvency in business terms.

 

 

Common causes of insolvency

What is insolvency in business terms?

A constant threat.

Insolvency can hit any business and isn’t always indicative of mismanagement. There are multiple factors that can suddenly plunge a company into insolvency. Here are just a few of the most common causes.

 

An economic downturn

Unfortunately, companies are vulnerable to many external headwinds that are entirely out of the hands of business owners. Economic recessions can take a sledgehammer to revenue and profitability, especially for those that trade in the luxury sector.

When money becomes scarce for many though, it tends to have a negative effect on almost all businesses.

 

Cash flow problems

The careful management of cash flow is crucial in avoiding insolvency. If your business is just an unexpected bill or late customer payment away from trouble, its cash flow needs urgent attention.

 

Over-borrowing

Some business owners are tempted to take out loans for as much as they can without a solid repayment plan in mind. Make sure that any finance deals your business takes out include repayments that will be affordable enough to pay without too much strain

 

Market changes

Another external change to look out for. Shifts in trends can see a booming business start to struggle almost overnight. Directors need to keep a close eye on changing trends to ensure that their businesses don’t get left behind.

Competitors can also alter the market by narrowing the market share your company holds. The strengthening of a rival or new companies competing in your sector can hurt businesses that stand still.

 

Legal issues

Any legal action taken against a business can understandably put them under pressure quite quickly. This makes adherence to regulations and laws vital for companies.

 

 

What you need to look out for

By having some knowledge of what to look out for, you can start to make informed choices on what happens next. We’ve outlined where things usually start followed by some of the options that may be available.

 

Spot the early warning signs

Lower turnovers, increases in customer complaints or returns, and declining margins are all signs of financial stress.

 

Statutory demands/winding-up petition

Creditors can take action (statutory demands) against a company, making the company vulnerable and leading to a winding-up order. If this is the case, it’s still possible to handle the situation or find a way to keep the business stable. Doing this, however, will require considerable skill.

If you receive a winding up petition or statutory demand and have not sought advice from an expert as a director, you need to do so now.

 

Opportunity to rest/think/plan

Companies can also have a moratorium against creditors, all thanks to the Corporate Insolvency and Governance Act 2020. This moratorium is granted as a rescue option for a company that cannot pay its creditors and gives the company breathing space to develop a restructuring plan. By doing this, companies can continue with their activities while seeking prospective buyers or realise the company assets for the benefits of its creditors. A moratorium is not a final solution and seeking one demands careful consideration.

 

 

What can you do about insolvency?

If your business is facing insolvency or you suspect it could be on the horizon, it’s important to take swift action.

 

Rescue options

Get help from professionals

The first and most crucial step is to consult with a business consultancy that specialises in business recovery. Our team at Forbes Burton includes several experts in insolvency and company rescue that can help businesses get back on track

 

Talk to creditors

It’s always worth having a conversation with suppliers and other creditors about the possibility of better repayment terms or even an extended deadline. As long as you’ve been good with repayments in the past, a supplier would probably prefer to tweak your repayments slightly and keep a client, rather than refuse and potentially lose one.

Read – How Fast Track Company Rescue Plans Can be Used to Save Businesses

 

Borrowing

A large asterisk should appear next to borrowing as a means of navigating away from insolvency. As you can probably appreciate, an unwieldy loan can potentially cause even more damage by adding to your company’s debt.

If, however, your current issue would be resolved simply by a client’s earlier payment of a job, then a bridging loan can make sense.

 

Invoice factoring

Another method of bringing forward the payment of unpaid invoices is to sell them to a factoring company. Factoring services buy invoices from businesses in return for a small cut of the invoice total (typically 10%, but can differ). Once bought, they assume responsibility for its payment and will usually send you another smaller payment once they’ve ensured it’s been paid.

If you can afford to let a small percentage of the invoice total go, then factoring is a great way to free up funds fast. It also has the added benefit of not putting your business into any extra debt. Our business finance team can talk you through the factoring process to help you decide if its right for your company.

 

Company voluntary arrangement (CVA)

A CVA is a legal process that allows a business to reach an agreement with its creditors to repay debts over a fixed period. This can provide breathing space while the business recovers and continues to operate.

Read – How Can a Company Voluntary Arrangement Clear Debt?

 

Restructuring

If you decide to battle on, then you will have to seek professional advice to help devise a means to source additional funds and minimise costs.

 Restructuring can often streamline processes and cut unnecessary bulk from a business. You may be able to improve your company’s financial standing by selling non-core assets, reducing staff numbers, or renegotiating contracts.

Read – The Benefits of Restructuring Your Business

 

Administration

Administration needn’t necessarily mark the end of the company. If your business is still viable then an administration can ringfence its assets while it restructures or finds a buyer.

A company may be put into administration if it is no longer able to settle debts. The administrator (an insolvency practitioner) takes over the company’s affairs and is tasked to achieve specific statutory objectives like rescuing the company, if not possible, deliver better results for creditors in general than if the business were liquidated. Placing a company under administration prevents creditors from taking action against it (moratorium).

Possible outcomes from a company under administration include a company voluntary arrangement (CVA) or company voluntary liquidation (CVL). Selling all or part of the company to a third party is another common outcome, and the proceeds are used to settle creditors. This act may preserve the business and jobs, but some creditors and shareholders may suffer loss.

Read – An Overview of Limited Company Administration

 

Closure Options

If you have had enough or there is no realistic way of turning the situation around then you will need to consider closing the company. This leaves you with two ways forward:

Liquidation

If there is no realistic chance of recovery, liquidation may be the best option. This involves selling the company’s assets to repay creditors. There are two types of liquidation for insolvent companies: compulsory liquidation, initiated by creditors, and voluntary liquidation, initiated by the company directors.

Read – Guide to the Limited Company Liquidation Process

 

Dissolution

If there are no assets to fund a liquidation, or the company has no debts than it can explore the use of a dissolution. Directors should be aware that the process needs to be carried out properly to fulfil their legal obligations.

Read – What is the Meaning of a Dissolved Company?

 

 Compulsory liquidation

Compulsory liquidation (by court order) is likely inevitable if the directors of a company cannot change the fate of a failing company. Assets belonging to the company are liquidated in the event of a liquidation, and the proceeds are distributed to the creditors; the shareholders may get proceeds if it is sufficient.

 

 

What if I need to liquidate, but don’t have the funds to do so?

Liquidation is the widely used term for closing an insolvent company, and the process is overseen by an insolvency practitioner (IP). In many cases though, instructing an Insolvency Practitioner is neither appropriate or viable.

Your first step should be to get in touch with one of our insolvency specialists. We’ll talk through the various options which are suitable for your company and establish whether an insolvency practitioner is required to ease the situation.

Here, we have compiled the various paths open to directors that need to close their company, but aren’t in a position to achieve this personally.

 

My limited company is being wound up by a creditor – why choose a creditors voluntary liquidation (CVL)?

We do understand that most can’t see the logic behind opting to pay for a liquidation which has already been funded by a creditor in the form of a winding up petition.

The primary reasons for going through the process voluntarily though, include:

• You are far more in control of the process
• You can choose your liquidator
• Wind-ups are overseen by the official receiver (appointed by the crown). While the overall process is similar to a CVL, compulsory liquidations involve a much more intrusive investigation into whether any wrongful or fraudulent trading has gone on
• The appropriate time for the company to go into liquidation can be chosen
• Waiting for someone to wind the company up rather than doing it yourself poses the risk of continuing to trade an insolvent company, which is classed as wrongful trading
• There are several ways to fund the CVL process.

 

How do I know if my limited company is being wound up?

You will receive notice of this. In the vast majority of cases, a statutory demand is issued as a warning before winding up proceedings are submitted.

A petition will then be delivered and signed for. If you have received either of these warnings, you need to get in touch now to discuss your options.

 

A liquidation may cost less than anticipated

Unfortunately, you cannot easily google how much a liquidation would cost and expect to find an accurate answer. This is because the cost will depend completely on the individual circumstances of the company. However, speaking to the right people helps.

All it will take is a 10-minute chat with one of our advisers to establish an estimated cost, with no obligation whatsoever.

We do find that many directors who have had a look online before speaking to us are pleasantly surprised at the low costs that we are able to offer.

 

So, how do I find the funds to pay for liquidation?

Sale of company assets

One of our initial questions when we are establishing how to fund a liquidation is regarding the company assets. Liquidator costs may be met by realising the assets available.

An RICS (Royal Institute of Chartered Surveyors) valuation expert would need to assess prior to an instruction on this basis, but this can be arranged quickly.

If the assets can cover some but not all of the IP’s fees, of course this can still be arranged.

 

Director’s redundancy pay

Many directors are not aware that they may be eligible for redundancy if they have an insolvent company. If we consider that your redundancy claim is likely to cover all or part of the IP’s fees, we would be happy to look into this for you.

You will be eligible if:

• Your company enters liquidation
• You are on the company payroll
• You work(ed) in the company for at least 16 hours per week
• You have been doing so for a period of more than 2 years

Usually in this case, we would obtain the information needed to provide a redundancy estimate, and feed this back to you along with the liquidation quote.

On comparison of these two figures, you can make a better informed decision from there.

Within the redundancy estimate we would also include notice pay, holiday pay and unpaid wages.

If you decide to go down this route and your redundancy estimate covers the costs of the liquidation, our practitioners are able to take instruction on this knowledge.

Once the payment comes through, they can use this to cover their costs and anything left over, of course, goes to you personally. If the redundancy pay out comes up short, the rest can be arranged on a payment plan, if this is the only available option.

 

Funding the liquidation personally

If you are in a position to personally fund the liquidation, this option can be taken. When there are no other options, it is common for directors to fund liquidations by selling their personal assets.

We must re-iterate that this is only recommended by Forbes Burton when there are no alternatives. After all, limited entities are legally separate from their directors and employees for a reason; to protect the associated parties from becoming effected personally when things go downhill.

However, by choosing to take on the direction of a limited company, individuals do undertake certain obligations. Fulfilling these will lessen the chances of personal liability in the future, especially if your plans are to continue within another entity.

Our insolvency practitioners pride themselves on being flexible and understanding the difficult positions that directors are often in when they first contact us. For this reason, they are able to offer payment plans to those that require them.

 

Dissolution

Dissolving the company is a further option; this is the informal equivalent of liquidation, and costs considerably less than liquidation due to the fact that an Insolvency Practitioner does not need to be instructed.

Although this is a far simpler process, there are still certain statutory requirements that you must fulfil in order to close the limited company lawfully.

If we were to undertake the dissolution process for you, we would deal with all creditor correspondence and ensure that your position is not compromised.

Keep in mind here that if your company was to be closed improperly, you could be found personally liable for limited company debts, whether this is through the liquidation process or not.

Because of all of the above, it is always worth seeking advice from one of our insolvency experts before deciding which path to take.

 

 

Note – Taking advice from accountants on an insolvent company

Please be aware that your accountant may not be an insolvency expert.

Although they may be a trusted individual, have always been on your side and know their stuff when it comes to business, their insolvency advice should still be taken with a pinch of salt.

Unfortunately, we come across a high number of cases in which the director of an insolvent company has been advised wrongly by their accountant and come under fire as a result.

Just know that however knowledgeable your accountant is, that unless they have come from an insolvency background they will not be familiar with insolvency legislation. Therefore, they are not in a position to advise you about your insolvent company.

Remember when taking insolvency advice from an accountant, that they’ll lose a client if your business closes. If it is later discovered that the company has been trading whilst insolvent (or conducting any other misfeasance), it is not the accountant at risk of personal liability, but the director.

As a rule of thumb, if you have an insolvent company and it no longer seems to be viable without your personal situation being affected, then it needs to close.

You would be surprised how many limited company directors we have come across whose accountants have advised them to take out personal loans to pay company creditors!

 

Finding the cheapest liquidation

Another situation that we come across is that directors take our advice and then search elsewhere for a cheaper liquidation quote.

Of course, we offer non-obligation advice because we fully support individuals exercising their right to shop around in a competitive market. However, please be clear of your terms before you sign on the dotted line.

Unfortunately, there are liquidators out there who severely under-quote for their services in order to take instruction on for further gain down the line.

Some see large asset lists or the fact that the director is in a positive financial situation, and use this to their advantage later on by charging hidden costs.

We value transparency and have built our reputation on helping businesses with their problems. Our panel of insolvency practitioners look after our clients, because if they didn’t, we wouldn’t work with and recommend them.

We’ve come across many who have been enticed by a cost that looks very low, but later find that they end up paying far more out of their personal funds.

By the time they come back to us, it’s often too late. Please be aware of the practitioner’s intentions, whichever path you choose. We would be happy to provide you with a few choice questions to ask.

 

Approaching insolvency

When a company is consistently pursued by creditors, and appears to be approaching insolvency, it becomes the director’s responsibility to place creditors’ interests before those of the company’s

This distinct shift in focus is required to avoid personal liability for company debts, and potential accusations of unlawful trading.

It’s a legal requirement for company liquidators (insolvency practitioners) to report on the conduct of directors, but there are actions you can take to mitigate the risks of wrongful trading allegations.

 

Be open with creditors

Creditors’ interests should be at the forefront of your mind as the director of a company facing insolvency. Minimising creditor losses is the ultimate aim, and engaging with them in an open manner should gain their trust. Provide them with accurate information when requested, and keep the lines of communication open.

 

Take professional advice

Knowing exactly when to cease trading can be difficult. It’s a fine line between the company experiencing ongoing financial difficulties, and the descent into formal insolvency. A professional Insolvency Practitioner (IP) will guide you, and be able to help you avoid accusations of trading while insolvent.

As a director, you may feel the need to carry on trading for honourable reasons, such as staff retention, but it’s an area that requires professional support.

 

Don’t put your own money in

There’s no obligation to put your own money into the company in an attempt to save it from failure. Its limited liability structure makes it a separate legal entity, with no liability implied for you as a director. The only time you may become personally liable is if business has been conducted improperly.

 

Keep a written record of all meetings

It’s a good idea to hold frequent board meetings to review the changing situation. Closely monitoring the company’s financial position demonstrates a commitment to dealing with these issues, but it is also important to keep a written note of all discussions, to record how and why decisions were made, for example, and the steps you are taking to recover and control the situation.

 

Maintain clear financial records

If a clear route into insolvency can be seen from company financial records, it may help to shorten the duration of an investigation. Keeping detailed and accurate financial records, and making them readily available to the IP will smooth out a difficult process. Use your accountant to help you to gather this information, if necessary.

 

Do not incur further credit

This will worsen the position of creditors as a whole, and could be viewed as acting in an improper manner. You may think that incurring further credit to trade yourself out of the situation is a good idea, but when you are approaching insolvency, you need to reduce expenditure and consider the effects of your actions on existing creditors.

 

Protect company assets

The value of company assets must be protected, so make sure they are insured and secure. Directors who try to sell company assets, or otherwise dispose of them, can face allegations of misconduct during an investigation. This includes moving assets into another company or giving them to creditors in lieu of payment.

 

 

Preventing insolvency

While addressing insolvency is all well and good, prevention is always the best strategy. Here are some tips to help your business avoid insolvency.

 

Strong financial management

Maintaining a clear and up-to-date financial plan will help your business stay on track. Ensure that you also review your cash flow regularly and ensure you have a buffer for unexpected expenses.

 

Diversify revenue streams

If your business is overly reliant on one source of income, be that from a single client or single product offering, it’s over-exposed to risk.

Try to diversify these aspects of your business to mitigate the risk of external forces impacting upon your company.

 

Cost control

Regularly assess your company’s costs and be prepared to eliminate unnecessary expenses. This will ensure that you maintain a healthy bottom line.

 

Stay abreast of industry news

Directors that are aware of upcoming market trends and regulatory changes can put provisions in place to prepare for them and even profit from them.

It’s a good idea to stay up-to-date with current global affairs too. If your main supplier sources most of their products from China, for example, new Chinese employment laws or workers’ strikes could have a serious impact on your business

 

 

Need to speak to someone?

Insolvency is a challenging situation that no business owner wants to face, but it is a reality for many in the UK. Understanding what insolvency entails and the options available can be instrumental in safeguarding your business’s future.

Seek professional advice, explore available solutions, and, whenever possible, focus on preventing insolvency through effective financial management and strategic decision-making.

By taking proactive measures, you can increase the chances of your business not only surviving but thriving.

Still need some help? Talk to us today about your needs.