Published on 14 November 2010 by Tony Groom

A company can be said to be insolvent on any one of four tests: the cash flow test, balance sheet test (negative asset value), an unsatisfied judgement (usually a county court judgement) or an outstanding statutory demand.

Of these four the most crucial is the cash flow test which looks at whether a company can pay its liabilities as and when they fall due where late payment of creditors indicates that a company is suffering cash flow problems. Running out of cash is the cause of most business failures and it can happen for a number of reasons.

The principal three reasons for not having access to cash are the bank freezing the company account, a restriction in the company’s ability to draw down funds possibly due to the lack of available credit and thirdly, a sales ledger issue where the company can’t draw down funds from factoring either because invoices have not been logged, or because of declining sales, or overdue or disputed invoices.

If the company’s relationship with its bank is under pressure then the causes and effects must be examined. Banks generally would prefer not to close down businesses and only usually start to get tough if  a business consistently tests its overdraft limit, company cheques cannot be honoured and the business does not  communicate or  provide sensible financial information if asked for.

It may be that the company is forced into an onerous factoring arrangement that will benefit the bank but can reduce funds available putting further pressure on cash flow. Again a rescue adviser will be in a better position to assess this objectively as all too often directors make the mistake of injecting personal funds without advice.

If the sales ledger system is not being kept up to date accurately or there are issues with suppliers over invoices then the system needs to be looked at thoroughly and a more robust set-up may need to be put in place.

In terms of cash outflow, there are two main tensions that can result and they are the inability to pay outstanding bills and the inability to pay future bills. In this situation prioritising payments becomes essential.  This is critical if a company has decided it is insolvent because it must act in the best interests of its creditors and needs clear principles for making payments to avoid personal liability.

In these circumstances unless a company is familiar with this sort of situation it would be advisable to take advice from a specialist restructuring adviser or insolvency practitioner.

Not only that but a company’s workforce very quickly become aware that there are problems and when people are worried about their job security they are likely to be distracted and less focused on doing the best job they can.

It is no good relying on one big contract to solve the problem even if the directors believe that the situation is a short term one.

It may be that the cash flow problem indicates a more deep-seated problem and even if the short term problem does ease, the structural weaknesses in the business, if ignored, will mean the situation will arise again.

A restructuring adviser will have a number of strategies available to help and it may be that at its core there is a viable business waiting to be unlocked.

If it is clear that the management has accepted that it needs help and called in a rescue adviser, who will work as part of the team and whose interest will be in helping the company to survive and grow.

Although the adviser will want to first look at the business in detail to establish whether all or part of it is viable before advising on any strategy.

However, if such help has been called in then the work force, too, will be reassured and people will be likely to work with more focus as part of the whole team, (that includes rescue adviser, management and workforce) in a common bid to secure all their futures.

A cash flow crisis is an alarm bell sounding that should indicate that the business needs to be properly assessed with experienced outside help.