A company is usually deemed to be solvent if the assets are greater than liabilities but there are two tests a company must pass to be considered solvent: The ‘balance sheet’ test and the ‘liquidity’ test.
Section 4 of the Companies Act 1993 sets out the meaning of the solvency test. A company is solvent if both of the following are satisfied:
- Liquidity Test
The company is able to pay its debts as they become due in the normal course of business
- Balance Sheet Test
The value of the company’s assets is greater than the value of its liabilities, including contingent liabilities.
It is common for directors to assume their company is solvent by satisfying the balance sheet test alone but when asked if they can pay their current bills the answer is often “no”. A company is not required to meet the solvency test on a day to day basis as it is not uncommon for companies to trade in and out of solvency as they operate but there are times when passing the solvency is required, including:
- Dividend distribution
- Repurchase or redemption of shares
- A reduction of shareholder liability
- Purchase of a major asset
The director(s) will need to sign a solvency certificate to confirm that the company will be solvent immediately after the proposed transaction has happened.
Knowing whether their company is solvent should be a part of good management for a director. There are implications for directors if their company is trading whilst insolvent. The common one is reckless trading.
The perception in the market place is that reckless trading prosecutions are rare, and they are, but what is not rare are settlement agreements between directors and their company’s liquidators when directors have run their affairs recklessly.
Also looming as an increasing risk for accounting firms is imprudent advice given by accountants to their clients regarding the solvency of their business. The most common mistake accountants make is to advise their clients to take drawings rather than income, to reduce the cash drain of PAYE on an unprofitable business. At the time this can seem a prudent accounting decision but opens the accountant to a claim by the director if they are later forced to repay their current account.
There are many definitions of solvency and even though a company may trade in and out of solvency day to day, it is important to consider where the line is drawn. Recent case law determines whether the risk the director took is a ‘legitimate business risk’. The ‘South Pacific Shipping’ case is a good guideline to determine the above. It is also important to note that a non-active or sleeping director may also be held responsible, as in the case of Lewis v Meltzer.