Indicators of Insolvency The Courts frequently need to consider whether or not a company or individual is insolvent and if so, when that insolvency started and when people should have suspected it. This usually occurs when a liquidator or trustee commences a recovery action. It is also a critical issue for directors of companies when liquidators or creditors commence an action for the recovery of damages arising from insolvent trading or related claims. Because this issue frequently arises, some Judges have developed indicators of insolvency that they look for when considering the question. These are indicators that directors and other parties should use when considering whether a person or business is insolvent. This issue was discussed in detail in ASIC v Plymin (2003) 46 ACSR 126, with the Judge referring to a checklist of 14 indicators of insolvency. 1. Continuing losses Not every business that makes a loss, or a series of losses, is insolvent. As long as working capital is available to meet those losses, insolvency can be avoided. Losses by themselves do not cause insolvency. Rather, insolvency is usually brought about by a combination of losses and insufficient working capital. This statement may seem obvious; however, some people concentrate solely on the losses without considering the capacity to absorb those losses. On the other hand, a large loss or series of losses may disclose a trend which counters any defense that expected future profits will overcome what otherwise might be a short term problem, and raise questions on whether working capital is truly sufficient to absorb such losses. When assessing insolvency, consideration should be given to working capital and the extent to which that working capital might be depleted by trading or other losses. 2. Liquidity ratio below 1 Liquidity is a measure of the extent that liquid assets are available to cover payable debts. The business's liquidity ratio is a comparison of its current assets and current liabilities. If the ratio is greater than 1, there are more current or liquid assets than current or payable debts and an indication that the business should be able to pay those debts. If the ratio is less than 1, the opposite applies. Whilst the liquidity ratio provides a pointer to solvency, it is by no means conclusive. A liquidity ratio measures available assets at a specific point in time and does not take into account the dynamics of cash flow and whether current debt is actually payable at that particular time. A further difficulty is that the ratio is usually determined using funds in the bank, rather than allowing for funds that might be borrowed from the bank. Amounts such as unused overdraft facilities will need to be included in a consideration of solvency. It also does not take into account whether current assets are truly liquid. Business owners should examine the reasons for a liquidity ratio that is less than 1 and determine whether some action should be taken. 3. Overdue Commonwealth and State taxes Many short-of-cash businesses regard the non-payment of taxes as the easiest way of saving some cash flow that may be essential to survival. They see it as borrowing the money from the government. They reason that there are no application forms to complete, no valuations to obtain, no bank fees to pay and no cut off of supply or repossession to worry about, and if interest has to be paid, that interest or penalty may not be applied for some time and might even be negotiable. So is non-payment of tax commitments (whether GST or PAYG) a good indicator of insolvency? The broad answer is, yes. Leaving aside those who may simply have an extreme aversion to paying tax, businesses will normally meet their obligations to the tax
2 office by the due date or soon thereafter if they have the ability to do so. In most cases those business that do not pay tax, cannot pay tax. Business owners need to carefully consider solvency whenever taxes remain unpaid. 4. Poor relationship with present Bank including inability to borrow further funds Banks have a distinct advantage over the other creditors. The bank knows what funds are on hand and can analyze the flow of funds through the bank account. If the business has borrowed money from the bank, the business owners will usually have to provide financial information from time to time. Usually none of this information is available to other creditors. A poor relationship with a bank usually stems from either (1) the non-repayment of monies due to the bank, (2) the bank being placed in a position where it must regularly dishonour cheques, or (3) the bank's assessment of the financial position or management of the business. A strained relationship with a bank does not prove that the customer is insolvent, just as a good relationship is not proof of solvency. Cases occur where the bank is amongst the last to know of a customer's insolvency because the customer has operated within agreed limits with the bank, while not paying other creditors. Although a poor relationship may be the result of other factors, it may be the result of the bank's lack of confidence in the business and its solvency. Certainly if a bank refuses to advance further funds or calls up a loan or overdraft, the reasons for this needs to be established. Further, the result of the bank refusing further funding may - and often will - cause insolvency. 5. No access to alternative finance 6. Inability to raise further equity capital Insolvency is determined on a cash flow basis - an ability to pay debts. This reflects the definitions contained in the Corporations Act (for companies) and the Bankruptcy Act (for individuals). An entity is insolvent if it cannot pay its debts as they fall due. The inability to pay debts is linked directly to the inability to obtain ready cash and to debts being "due and payable". Three financing alternatives are available to businesses with cash shortfalls: a) The debtor can convert short term debt to long term debt, being debt repayable at some date in the future or intermittently over that period. If a debt is no longer 'due and payable' now it does not form part of a strict solvency calculation. But, a creditor doing nothing to collect debts that are outside of agreed terms cannot be taken as an implied agreement to extend trading terms. b) Businesses may borrow funds to be used to pay due debts. Care must be taken not to mislead the lender, even if the loan is to satisfy current debt and alleviate current cash flow problem. If the entity eventually fails, the obtaining of the loan may have consequences to the business owner or director. c) The debtor can obtain funds in the form of equity capital. Equity capital is not debt. Equity, while seeking an eventual return from profits, does not compete with debt for repayment. Potential equity investors, knowing that an eventual return may be delayed or uncertain, are likely to be diligent in reviewing the finances and prospects of the venture in an effort to be satisfied that the return is commensurate with the risk. Being unable to convert sufficient short term debt to long term debt, or borrow money to overcome a cash crises, or is unable to replace debt with equity to cure the lack of funds, is a strong indicator that the business has at least a cash flow problem and is possibly insolvent - rather than simply suffering a cash flow problem that can be resolved in the short term. 7. Suppliers placing the debtor on COD, or otherwise demanding special payments before resuming supply 8. Creditors unpaid outside trading terms
3 Individual creditors are the first to know that their invoices are not being paid on time. An efficient credit manager or business operator will have systems that identify overdue accounts and prompt collection action. Action may consist of collection letters or calls and may involve limiting further supply to a C.O.D. basis or ceasing supply entirely. Being placed on C.O.D. terms tells the customer that, at least temporarily, the supplier has no faith in the customer's ability to meet further credit commitments - and this is usually because there are outstanding debts to suppliers in the industry. It might be thought that, if a business has a range of creditors with accounts outside of agreed terms, then that business must be insolvent. However, care must be taken to determine whether the business is a chronic late payer of accounts, even though the business had sufficient funds to do so. Business owners have to determine whether debts are not being paid because there is either no money to pay them or other reasons. 9. Issuing of postdated cheques. The issuing of a postdated cheque for current debt is one of the classic signs of insolvency. It is also one of the major signs of hope by both the debtor and the creditor that the money will be there when the cheque gets presented. Understandably, some creditors take the receipt of a postdated as a sign that their account will eventually be paid, but it must be remembered that the issuing of a post dated cheque amounts to an admission by the debtor that there are insufficient funds to pay now. Whether it also amounts to a creditor extending the credit terms to the date shown on the cheque is far less certain. Solvent debtors very rarely issue postdated cheques as these cheques immediately raise suspicions of insolvency. A debtor who has a long-term history of issuing post dated cheques is almost certainly insolvent and relies of further monies to pay current commitments. On the other hand, a debtor who very infrequently resorts to post dated cheques is more likely to be suffering a short term cash flow problem rather than insolvency. 10. Dishonoured cheques. Many postdated cheques end up being dishonoured on presentation. The issuing of postdated cheques is sign of often misplaced optimism and a strong indication of insolvency. The dishonouring of a postdated cheque sends a very clear message that the debtor's problems are more than simply a short term cash flow problem. The dishonouring of a post dated cheque tells us that the debtor's cash flow is at best inadequate and that the debtor's bank has limited faith in the debtor arranging for funds to pay the account. Generally a cheque is dishonoured by a bank because there are insufficient funds available to cover the payment. Occasionally, of course, that position comes about through inadvertence or through no fault of the debtor. Accordingly the dishonour of one cheque or even a few cheques at the one-time should not necessarily be taken as clear evidence of insolvency. But when the debtor's bank repeatedly dishonours cheques a conclusion of insolvency is unavoidable. The lack of sufficient funds to cover cheques issued must equate to an inability to meet all debts when they fall due. That is the classic definition of insolvency. 11. Special arrangements with selected creditors 12. Payments to creditors of rounded sums, which are not reconcilable to specific invoices Not all demands from creditors end in summons and judgments. If the debtor does not dispute the existence of the debt, but cannot arrange immediate payment, creditors' demands may result in some form of repayment agreement. These repayment agreements usually allow for payments to be made over an extended period of time, and it is not unusual for the payments to be made in round dollar amounts. This is why we are dealing with these two items together.
4 Entering into such an arrangement is an admission that the business cannot meet the full debt when due, otherwise the arrangement would not be necessary. It is not uncommon for such an arrangement to be completed as planned, with both parties satisfied with the outcome. Can a debtor cure its insolvency by negotiating extended payment terms with creditors? In our view the answer is yes, provided that the further time for payment arises out of a clear agreement by the creditor to provide extended terms. Once the terms of a debt are extended, the entire amount is no longer due and payable. Round payments may be made in reduction of a debt with the agreement of the creditor. But it is not unusual to find round amount payments being made without such an agreement. The payments are usually made in that fashion because the debtor cannot pay the debt in full and that the debtor is not confident of negotiating extended arrangements with creditors. The debtor hopes to obtain extended credit terms by default by making part-payment. This debtor is almost certainly insolvent. 13. Solicitors' letters, summons, judgments or warrants issued against the company A single letter of demand from a creditor or their solicitor is not proof of insolvency, as there may be a real dispute between the parties. A series of demands from a number of solicitors, however, should create a strong presumption of insolvency. It would be unusual for a business to have a large number of disputes with their suppliers at the one time. If the creditor moves beyond the demand stage and obtains a judgment that remains unpaid, the presumption of insolvency is all but confirmed. When execution of the judgment is undertaken by the creditor, a state of insolvency is certain. 14. Inability to produce timely and accurate financial information to display the company's trading performance and financial position, and make reliable forecasts This indicator has links to section 289 and section 588FE of the Corporations Act, which deal with the deeming of insolvency when a company has not kept proper books and records. But it does not logically follow that a business is likely to be insolvent simply because it has not prepared accurate financial statements or made reliable financial forecasts. We can certainly conceive of a solvent business that is unable to prepare accounts, at least in the short term, because an incompetent accountant has allowed records to become disorganized. Yet experience tells the courts that insolvency and having financial records in disarray generally goes hand in hand. Not only do insolvent entities almost always have inadequate accounting records, they also frequently demonstrate a real reluctance to prepare reliable and timely accounts. This is arguably the weakest of the indicators viewed objectively, but subjectively provides an accurate indicator of the likelihood of insolvency. Historically we have found that insolvent entities that have up-to-date financial information are very much the minority. Businesses in financial trouble generally spend their energy trying to get out of financial trouble, not preparing the financial picture and planning the way out of trouble. Without financial information, the business owners will not know the extent of the deficiency (this is very common) and they will not be able to convince bankers or other creditors that there is a solution to their difficulty. Summary This begs the question of how long a short term cash flow problem can last before it becomes a case of insolvency. A shortage of funds can only be described as a short-term cash flow problem if it is certain that problem will be overcome in the short term. Placing a time period on overcoming the problem is more difficult, as some cash flow problems may be seasonal or caused by specific contractual problems. We are unaware of any judicial pronouncements on that point. However, as a general rule, we would expect that a true short-term cash flow problem should be solved within a period of three to four months, and at that time all debts would be up to date.
5 DISCLAIMER The enclosed information is of necessity a brief overview and it is not intended that readers should rely on the information contained herein. No warranty express or implied is given in respect of the information provided and accordingly no responsibility is taken by Debt Options Pty Ltd or any of its employees or agents for any loss resulting from any error or omission contained within this fact sheet. The information provided herein is not advice it is merely general educational information. Do not rely upon any information provided herein without first consulting a lawyer. Whilst every effort is made to keep this fact sheet up to date, changes in legislation may have caused the information contained herein to be superseded or changed.