Insolvency occurs when a business or an individual is unable to meet their debts as they become due and payable.
Section 95A of the Corporations Act 2001 (Cth) defines solvency and insolvency as follows:
- A person (including a company) is solvent if, and only if, the person is able to pay all the person’s debts, as and when they become due and payable.
- A person who is not solvent is insolvent.
At common law, there are two tests for insolvency.
- The cash-flow test: assesses the ability of a company to pay its debts (or sell its assets fast enough to pay its debts) as they become due and payable.
- The balance sheet test: assesses the solvency of a company in reference to the total external liabilities against the total value of company assets. If liabilities exceed assets, the company is insolvent.
The cash-flow test is the principal test used by the Courts because it follows the section 95A definition above. It requires an analysis of:
- The company’s existing debts;
- Whether the company’s debts are payable in the near future;
- The date each debt will be due for payment;
- The company’s present and expected cash resources; and
- The dates any company income will be received.
In ASIC v Plymin & Ors (2003) 46 ASCR 126, Justice Mandy of the Supreme Court of Victoria referred to a checklist of 14 indicators of insolvency:
- Continuing losses;
- Liquidity ratio below 1 (a ratio of current assets to liabilities);
- Overdue Commonwealth and State taxes;
- Poor relationship with present bank including inability to borrow additional funds;
- No access to alternative finance;
- Inability to raise further equity capital;
- Supplier placing the debtor on COD (Cash on Delivery) terms, otherwise demanding special payments before resuming supply;
- Creditors unpaid outside trading terms;
- Issuing of post-dated cheques;
- Dishonoured cheques;
- Special arrangements with selected creditors;
- Solicitors’ letter, summon(es), judgments or warrants issued against the company;
- Payments to creditors of rounded figures, which are irreconcilable to specific invoices;
- Inability to produce timely and accurate financial information to display the company’s trading performance and financial position, and make reliable forecasts.
For corporations, the three insolvency administration procedures available are voluntary administration, liquidation, and receivership.