Balance Sheet Insolvency Test Fails to Impress Supreme Court

Posted: 10th March 2011

insolvent balance sheetOne of the traditional definitions of insolvency when the liabilities of a business exceed its assets, leaving a balance of ‘net liabilities’. This is known in accounting circles as the ‘balance sheet test'. Another test, which is arguably more relevant in many cases, is the 'cash flow test' – simply, can the business meet its debts as they fall due?

With bank loans increasingly difficult to find, more and more companies are relying on overdraft finance and/or taking extra time to pay their bills, while still having sufficient cash flow to carry on trading on a day-to-day basis.
In a recent case, the Supreme Court threw a lifeline to companies which, while technically insolvent based on the balance sheet test, have sufficient cash flow to continue trading. The Court ruled that the ‘mechanical approach’ of declaring a business insolvent because it has failed the balance sheet test was inappropriate unless the business had truly ‘reached the end of the road’.