A company can look solvent on paper and still be insolvent in practice.
The point is often missed. Directors, shareholders and advisers look first to the balance sheet. The company owns a plant. It has debtors. It has work in progress. It has a pipeline.
But in New Zealand insolvency law, the immediate question is not whether the company has value. It is whether the company can pay its debts as they fall due. The solvency test in section 4 of the Companies Act 1993 has two limbs: the company must be able to pay its debts as they become due in the normal course of business, and its assets must exceed its liabilities. A company that fails the first limb is in difficulty no matter how the second looks.
The courts have described solvency as a “moving picture” of the company’s financial position rather than a still photograph. A snapshot of the accounts might suggest the company is asset positive. The moving picture may show something quite different: creditors waiting, payment arrangements being missed, tax arrears increasing, suppliers tightening terms, and cash receipts no longer arriving in time to meet current obligations.
“This issue is particularly common in construction.“
Construction businesses often operate with uneven cash flow. Progress claims may be delayed. Variations may be disputed. Retentions may be withheld. A profitable job on paper may not produce cash for months. A company can have significant work in progress and still be unable to pay subcontractors, suppliers, wages, rent or IRD on time.
That does not mean every cash flow squeeze is insolvency. A temporary lack of liquidity is not necessarily fatal. A company may still be solvent if it has a realistic ability to obtain finance, collect debtors, or realise assets within a relatively short period and in the ordinary course of business.
The word “realistic” is doing a lot of work.
It is not enough to say the company has value. Value only helps if it can be converted into cash when the cash is needed. A piece of equipment may have a market value, but if there is no buyer, no sale process, and no ability to realise it quickly, it does not assist with debts due this week. A debtor balance may appear recoverable, but if the customer disputes the invoice, or will not pay for 90 days, it does not meet tomorrow’s payroll. A bank may have historically supported the business, but that is different from an approved facility that is actually available.
A company in financial difficulty needs a working plan, not an argument about net worth.
A working plan might include confirmed funding, a documented and credible asset sale process, enforceable payment arrangements with customers, or formal agreements with creditors to defer payment. What matters is whether the plan is capable of producing cash in time to meet debts as they fall due.
The warning signs are usually visible before formal insolvency occurs. These include:
- undisputed debts remaining unpaid beyond agreed terms;
- IRD arrears increasing over successive periods;
- suppliers moving the company to cash on delivery;
- subcontractors threatening suspension or recovery action;
- payment plans being entered into and then missed;
- directors relying on one future receipt to solve several existing problems; and
- management accounts showing profit while the bank account tells a different story.
For directors, this is a governance issue as much as an accounting one. When a company is under pressure, directors need to keep testing whether the company’s assumptions are still realistic. Is the debt genuinely collectible? Is the asset sale genuinely achievable? Is the lender actually committed? Are creditors being paid in accordance with agreed terms, or is the business only surviving by stretching them further each month?
The answer may change over time. That is the point of the moving picture approach. Solvency is not fixed because the last set of accounts looked acceptable. It must be assessed against the company’s actual position as events unfold.
For advisers, the same discipline applies. A client will rarely describe itself as insolvent. It will say it is waiting on a claim, waiting on a variation, waiting on a refinance, or waiting on a sale. Those explanations may be valid. But they should be tested against timing, certainty and evidence.
Can the company pay what is due now? If not, what cash is coming in? When is it coming in? How certain is it? What happens if it does not arrive?
Those questions are more useful than asking whether the company is technically worth more than it owes. Net worth on paper does not pay creditors. Cash does.
The earlier directors confront that distinction, the more options they have. Those options may include restructuring, creditor arrangements, refinancing, asset sales, voluntary administration, or, where necessary, liquidation. The later the issue is addressed, the more likely the position will be dictated by creditors rather than managed by the company.
