A company is ‘insolvent’ when it cannot pay its debts in time, or when the total of its liabilities exceeds its assets. If a company becomes insolvent, it must cease trading. There are various arrangements that can be put in place to try to avoid a company becoming insolvent. These arrangements may be initiated by a company’s directors or creditors and involve placing differing levels of external control upon the company’s operations. The arrangement(s) chosen will depend on the aims of a company, the extent of its financial difficulties and the intentions of its creditors.
A brief overview of potential arrangements has been provided below, although any in-depth consideration of this topic is beyond the scope of this article:
- Loans/Raising Additional Finance: directors could renegotiate the terms of existing loans with creditors in order to give the company more time to repay those loans. The company should, where possible, avoid taking on additional debt as this could make the company less financially stable. Issuing new shares could provide a more viable source of additional finance, if demand for the company’s shares still exists (which may be unlikely).
- Profitability/Cash Flow: every effort should be made to improve profitability, including cost cutting and undertaking regular and thorough reviews of the company’s business plan/objectives/accounts. Directors should try to improve cash flow, perhaps by trying to extend credit periods with existing suppliers or finding cheaper alternative suppliers. Customer debts could also be collected more effectively and dividend payments should be temporarily suspended.
- Turnaround Specialists: directors could also consider consulting with turnaround specialists (who are responsible for helping companies to recover from financial difficulties).
However, if a company is insolvent or there is no reasonable prospect that it can avoid becoming insolvent, the directors must cease trading or could face legal action (e.g. a claim for ‘wrongful trading’).
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By Jake Schogger - City Career Series