Coronavirus (Covid-19) is having a major impact on businesses in all sectors around the UK. It has had a particular effect on hospitality, property, retail and leisure sectors.
Below is a short guide to understanding insolvency, and the steps that can be taken to assess whether a company, or individual, might be facing insolvency in these trying times.
What is insolvency?
Insolvency occurs when an organisation (or individual) has insufficient assets to discharge its debts, and therefore can no longer meet financial obligations to creditors as debts become due. It is a state of financial distress and can arise from various situations, such as poor cash management, a reduction in cash flow, or an increase in expenses. It differs in principle from bankruptcy, which is the actual legal process dictating how an individual will repay their creditors.
There are various ways of ‘testing’ for insolvency under the Insolvency Act 1986.
Cash flow test
Under s123(1)(e) of the Insolvency Act, a company is deemed to be insolvent if it is unable to pay its debts as they fall due (‘cash flow insolvency’).
The cash flow test analyses the ability of a company to pay its debts as they fall due, or in the very near future. This second stem is particularly important, as an organisation can be deemed to be insolvent under this test even if it can pay debts that are due at that moment in time, but it does not (or will not) have the resources to discharge debts that will fall due in the reasonably near future. If a company cannot pay its bills, now, or in the near future, it risks an unpaid creditor issuing a winding up petition.
The length of the “reasonably near future” will depend on circumstances, and the nature of the business, but taking into account events that are beyond the “reasonably near future”, this test becomes purely speculative, and a different test – the balance sheet test – becomes more useful.
Balance sheet test
Under s123(2) of the Insolvency Act, a company is also deemed to be unable to pay its debts if its assets do not exceed its liabilities, taking into account its contingent and prospective liabilities (‘balance sheet insolvency’). Therefore, if company liabilities exceed those of company assets, it is possible that a company could be on the verge of insolvency.
It is important to include future and contingent liabilities (that are possible to calculate at the time the test is being carried out) in this test. For example, deferred payments or potential litigation decisions against the company.
Debt to equity ratios
It is also important for a company to keep an eye on its debt to equity ratio. The more debt a company has, the closer it may be to insolvency. If it is the case that total liabilities are greater than total equity, the ratio will be greater than 1. This indicates that more than 50% of the company’s assets have been funded by debt, and if this ratio grows larger every year, this may indicate the company is heading towards insolvency. If the debt to equity ratio is lower than 1, then that means its assets are more funded by equity. Below are some examples of debt to equity ratios in varying sectors, although these numbers are very likely to change over the coming months, with the Coronavirus pandemic.
Airlines Easyjet and RyanAir at the moment have positive ratios of 0.64 and 0.69 respectively, with commercial banks Barclays and HSBC having ratios of 1.86 and 1.5 respectively. Car manufacturer Volkswagen has a ratio of 1.65, Marriot Hotels have a ratio of 16.82, with Weatherspoon’s having a ratio 4.6.
Why are these insolvency tests important?
If one or more of the above tests are failed, then the company will be deemed insolvent. Therefore, company directors must act as soon as possible to ensure the situation does not worsen. The tests are also important as directors can be held liable if a company continues to trade while it is insolvent. However, there have been recent changes to legislation in this area due to the Covid-19 outbreak to ameliorate the position for those business, organisations and individuals which are financially struggling.