Insolvency is an inability to pay debts when they are due, so factors that indicate the availability of cash to do so, or the lack of it, become important. Insolvency must be distinguished from a short-term cash flow problem, so these indicators look at factors affecting cash flow, as well as the availability of cash at any one moment in time.
An inability to raise equity or loan capital
As insolvency is a cash issue, businesses with insufficient cash to meet their due debts will have to raise the extra money to stay solvent. They have three main options.
1. The debtor can refinance by borrowing money on a long term basis effectively converting short term (due and payable) debt to longer term debt (repayable at some date in the future). If a debt is no longer due and payable it does not form part of any strict solvency calculation. Obviously when paying short term debt with long term borrowings care must be taken not to mislead the new lender about the borrower’s financial position, even if the loan is to satisfy current debt and alleviate current cash flow problems. Obtaining the new loan may have consequences to the business owner or director if the entity eventually fails.
2. The debtor can raise funds from equity capital (issuing shares) to pay due debt. Equity capital is not debt, and while seeking an eventual return from profits, it does not compete with debt for repayment and may be a more appropriate and safer method of obtaining funds. On the other hand, potential equity investors, knowing that an eventual return may be delayed or uncertain, are likely to be diligent in reviewing the finances and prospects of the business to be satisfied that the return is commensurate with the risk. Business owners will need to be able to prove solvency and future profits.
3. The debtor may enter into formal repayment agreements with its creditors. Even though this is an admission that the business cannot meet its debts in full (that it is technically insolvent), it may only be caused by a cash flow problem that can be resolved in the short term. Can a debtor cure its insolvency by negotiating extended payment terms with creditors? In our view the answer is yes, provided that the further time for payment arises out of a clear agreement by the creditor to provide extended terms. This is very similar to obtaining long term debt to satisfy due debt.
Not being able to convert sufficient short term debt to long term debt, replace due and payable debt with equity or negotiate repayment agreements must indicate insolvency to a cash-short business. It indicates that the problem is not simply short term cash flows, especially when it is compounded with ongoing losses and reducing working capital.
Issuing post-dated cheques or having cheques dishonored
Issuing a post-dated cheque is one of the classic signs of insolvency. It is also a major sign of hope – by the debtor and the creditor – that the money will be there when the cheque finally is presented at the bank. Understandably creditors take the receipt of a post dated as a hopeful sign that their debt will eventually be paid. But issuing a post dated cheque is an admission that there are currently insufficient funds to pay all due debts.
Solvent businesses very rarely, if ever, issue post dated cheques as it raises suspicions of insolvency. A business that infrequently resorts to post dated cheques is more likely to be suffering a short term cash flow problem – but they should know what is causing that problem and how and when it will be resolved. Any business with a long history of issuing post dated cheques is almost certainly insolvent.
A post-dated cheque being dishonored sends a clear message that the problem is more than a cash flow difficulty. It should tell business owners that (i) their cash flow is at best inadequate, (ii) their bank has limited faith in them covering the amount in the future, (iii) they could not arrange payment of the account even when given a second chance, and (iv) without a good explanation, that they are almost certainly insolvent.
Occasionally a cheque may be dishonored through inadvertence or through no fault of the debtor, so one cheque or a series of cheques being dishonored at the same time can not necessarily be taken as clear evidence of insolvency.
But when the bank repeatedly dishonors cheques it may confidently be assumed that the debtor is insolvent, as having insufficient funds to cover cheques issued to creditors must equate to an inability to meet all debts when they fall due – the definition of insolvency.
Payments in rounded sums and for the minimum amount
Sometimes debtors cannot or do not make repayment agreements with their creditors, and resorts to making a small payment to the creditor and these are usually in a round amount.
The debtor hopes that the small payment will delay the creditor taking any collection action and will continue supply. They hope that they can resolve the situation in the near future or that the creditor will be satisfied with a series of small payments. Payments made in this manner cannot be taken as an agreement by the creditor to extend the terms of the debt and does not have the same effect as a formal agreement.
It may be inferred that the small payment is being made in that fashion because the debtor cannot pay all of its debts as they fall due. The debtor hopes to obtain quasi extended credit terms by default, which is really just an attempt to buy some breathing space and continued supply.
This is one of the strongest indicators of insolvency, and technically there can be little doubt given the definition of insolvency. If the part payment does not satisfy the creditor, business owners will also find some of the Relationship indicators arising.
It is also not unusual to find that cheques are drawn when due – whether in round amounts or not and whether post-dated or not – but then sit in a drawer for many weeks and are released only when the creditor demands payment and funds are available to meet the cheque. Businesses that use this process to pay accounts rarely end up satisfying all creditors, no matter how long they hold the cheques. They are almost always insolvent.
Business owners that are constantly attempting to piece together informal payment plans must seriously consider the question of insolvency.
Overdue Commonwealth and State taxes
Many cash strapped or unprofitable businesses regard withholding the payment of tax commitments as the easiest way of generating essential cash flow. They reason that there are no application forms to complete, no valuations to obtain, no bank fees to pay, and no cut off of supply or repossession to worry about. If interest has to be paid, that interest or penalty may not be applied for some time and might even be negotiable. Simply, taxes and related debts are considered the easiest debts not to pay when sufficient cash flow is not available.
So is non-payment of tax commitments (whether GST or PAYG) a good indicator of insolvency? The broad answer is, yes. Leaving aside those who may simply have an extreme aversion to paying tax or where there is a real dispute, most businesses will normally meet their obligations to the tax office when they are due.
It may be assumed that any unpaid amount due to the tax office was not paid because the business did not have the capacity to make the payment and business owners should look at whether this position is likely to change in the near future, or the business is insolvent.