This week Richard explains the second insolvency test – the balance sheet test – and how to apply it to your company. He covers:

• why an unbalanced balance sheet is an issue.
• how your balance sheet can affect your business.
• why the external perception of your balance sheet matters.
• how an insolvency practitioner uses the balance sheet test.

Transcript:

Hello, I’m Richard Simms from FA Simms & Partners. 

You’re joining us today for the second part of our two-part series on the tests for insolvency. We did the cash flow test in the previous episode, and this is now to do with the balance sheet test. 

The balance sheet test might sound a bit obvious really, but it’s down to where the balance sheet basically is imbalanced. If it’s imbalanced negatively. By that, I mean, let’s think about an old-style set of scales, the old brass scales you’ll see in a picture somewhere. 

You’ve got two sides to it and if one side becomes heavier than the other side, one side drops down the other one lifts up. The heaviest side is the negative part of your balance sheet. So the bottom part of the company balance sheet. Effectively then you have a situation where the balance sheet is imbalanced.  

In other words, the liabilities and the money out becomes bigger than the assets that creates a negative reserves position for the company. You’ll see a negative position on the balance sheet and that is a technical insolvency definition. 

Now, why is it interesting? Because if I look at it with my insolvency investigation cap on, if I’m looking back at a company to see when this point of insolvency occurred with the company, if the company’s filed accounts and it shows the company was ‘balance sheet insolvent’ when the paperwork was filed, that’s a pretty clear indicator. The directors haven’t signed a piece of paper saying the company’s insolvent. So if that’s happened, that’s happened let’s say it happened five years ago and it gets worse. Or does it doesn’t change much every year for the next four years, the company has been insolvent for five years.  

Now, if the company was insolvent five years ago, there was a reason for it and steps are being taken to rectify that situation. And then year three actually turns out the company is solvent because actually, whatever the problem was has been resolved, that kind of resets that position. 

It’s similar to the cash flow test, actually, and it’s something to be aware of. You can be insolvent at one point and become ‘un-insolvent’ if there’s such a word. Effectively, so if you get back from a situation where you were in a negative position and it gets caught back up again, problem solved. You reset the insolvency time clock, which is important to recognise that. 

So just because your balance sheet’s insolvent this year, if you’re taking active steps – and it’s important you record and document the steps you’re taking to make it better and why you think it was a one-off situation that can be rectified – then of course it doesn’t rest as badly on your shoulders. 

But as a director of the company, if you blindly go forward with a negative balance sheet, negative balance sheet, negative balance sheet, year on year on year, you’re not helping yourself. Basically you put yourself in a difficult situation because if you don’t take any steps to rectify that position, your position is a concern. 

Now you could argue that the negative position might be only to people who are owed money who are connected to you. For example, other companies in your group or to people you’re close to – to yourself, for example. So you may say, well, no one else is losing out from me having a negative company balance sheet. But you are losing out because how do you think your suppliers, your customers, view your company if it’s showing a negative balance sheet? It’s going to make a big difference. And they’re gonna say, “Well, why would I put myself in a situation where I’m supplying goods to someone on credit who I already know is insolvent from the beginning?”

In the same way, if I’m a customer looking to buy from you, and I say, “Oh, let’s look at the company’s accounts, just out of interest,” which people do. I’ll quite regularly look at a credit report before I’ll do business with them. I think, “Well, I’m about to put the deposit down on a product I’m going to buy, but actually the company’s been insolvent from day one.” 

So do look at the bigger picture. Do do, please be aware of the impact it could have on your business from external parties looking at business and saying, look at your company saying, “Well, that’s insolvent. Why do we work with them?” People will review your reserves on a balance sheet test, will review your position. So if you cannot address that situation, you can’t see a way forward, maybe it’s time to bring that to a close. Maybe it’s time to consider the situation in more detail. Maybe get some advice about what you can do to improve the situation. 

But please don’t blindly go forward in a situation where your company’s showing an insolvent balance sheet without taking steps to address it. If you don’t, as I mentioned, people that see it externally maybe negatively. You put yourself in a situation where you, if you’re going to have to go through a full insolvency procedure at some point over the forthcoming time period, that is the date set by which for example, myself, as working as an insolvency practitioner (in this case I’ve got my insolvency practitioner cap on here), I’m looking back on the business and I’m seeing that point in time. 

So that negative insolvency position on the balance sheet is as important as the cash flow test. But we’ll look back as far as we can, to when the point of insolvency started. It could be the cash flow was the first problem you came across or it could be the balance sheet was the first problem you came across. Either way, we’ve got to track back, look at the available information to understand the situation. It’s not uncommon. 

Again, we would have to reconstruct the company business accounts to understand that, to make sure we knew what happened. We’ll normally be contacting the bank and asking for copies of the company bank account. It may be a PayPal account. It may be an Amazon account. Who knows what we’re looking for – we’re looking to get all the information we can do as part of our review process. Once the company’s insolvent, one the company’s gone into the formal process. 

So please, please, please have a look at the situation fresh while you’re still operational. Keep this as part of what you do. We talked about managing the cash flow previously and what you can do with your cash flow forecast. Here is about making sure you respond to issues in front of you. Do not allow things to go past, you don’t ignore things in front of you. 

So I’ll pull this bit to a close now. Please look out for making sure your balance sheet is solvent. Making sure you take advice if you do find your balance sheet in an insolvent position. And keep thinking about the consequences of not having that in place and making sure it’s as solvent as possible. 

Thanks very much. Thank you.