Insolvency

In plain terms

Insolvency is not the same as being short of cash for a week. In UK law it is a defined state, measured by two tests. The cash-flow test asks whether the company can pay its debts as they fall due. The balance-sheet test asks whether the company's total liabilities exceed its total assets, including contingent and future liabilities. A company can fail either test and be technically insolvent.

Insolvency is a condition, not an outcome. An insolvent company is not automatically closed down — but the moment a director suspects insolvency, their legal duty shifts from acting in the interests of shareholders to acting in the interests of creditors. Getting that timing right is one of the most important judgements a director makes.

Why it matters to your business

Recognising insolvency early protects both the business and the director personally. If directors keep trading and taking on credit while they know — or should have known — the company could not avoid insolvency, they risk personal liability for wrongful trading. The defence is to take advice and act to minimise creditor losses the moment the warning signs appear.

The encouraging news is that insolvency often has solutions short of liquidation: a Company Voluntary Arrangement (CVA), administration, or refinancing to bridge a temporary squeeze. Many businesses that look insolvent on a cash-flow basis are fundamentally sound and simply caught in a timing gap — exactly the problem that turnaround finance and working-capital facilities are designed to address.

An example

A profitable engineering firm wins a large contract but must buy materials and pay staff for three months before the customer pays. Mid-project, two suppliers demand payment the firm cannot meet that week. On the cash-flow test it is insolvent — yet its order book and balance sheet are strong.

Here the right move is not to panic into liquidation but to bridge the gap: chase receivables, talk to creditors, and consider short-term finance secured against the contract. Once the customer pays, the firm is comfortably solvent again. Timing, not viability, was the problem.