CORPORATE GOVERNANCE TRAINING MODULE 12: INSOLVENCY TESTS ADB Private Sector Development Initiative Corporate and Financial Governance Training Solomon Islands Originally by Dr Judy Taylor

Acknowledgments These materials were produced by Dr Judy Taylor from La Trobe University, through the Asian Development Bank’s Pacific Private Sector Development Initiative (PSDI). PSDI is a regional technical assistance facility co- financed by the Asian Development Bank, Australian Aid and the New Zealand Aid Programme. 2

Outline of session: 3 What is insolvency? How do I test for insolvency? Early warning signs of insolvency.

What is insolvency?  There are two definitions of insolvency.  Cash flow insolvency  Balance sheet insolvency  Cash flow insolvency occurs if the company is unable to pay their financial obligations as they fall due in the normal course of business.  Balance sheet insolvency, also referred to as technical insolvency, occurs if the Liabilities are greater than the Assets.

Insolvency defined  A company can be cash flow insolvent but balance sheet solvent  They can’t pay their bills on time but they have more assets than liabilities Or  A company can be balance sheet insolvent but cash flow solvent (often due to high levels of debt)

Applying the test for insolvency Cash flowBalance sheetOutcome InsolventSolvent (A>L)Stop trading, Call meeting review business, raise capital or sell parts of business InsolventInsolvent (A<L)Stop trading Call meeting appoint liquidator SolventInsolvent (A<L)? (high levels of debt) Call meeting Raise equity

Testing for Insolvency-Cash Flow  Cash Flow test  If a company has defaulted on its obligations, the company’s ability to pay its debts under normal circumstances of the company need to be appraised.  The test is not perfect or precise  Here the company focuses on the ratio of current assets(CA) to current liabilities (CL)  CA/CL must be greater than 1  The company in the normal course within a year, has more current assets than current liabilities.

Testing for Insolvency-Cash Flow  Temporary financial difficulties may not automatically deem a company insolvent if they have greater resources to draw on.  If CA/CL less than 1 and the company has no further resources to draw on it is insolvent. It cannot meet its obligations  If they have resources to draw on, such as raising capital, selling long term assets subject to total Assets remaining greater than Liabilities, they may not be insolvent. Amount of time to restructure becomes important and incurring new creditors during this period may be problematic.

Testing for Insolvency  Balance Sheet test If total assets are less than total liabilities and the company is meeting its cash flow obligations the test is whether the company can  Gather additional funds quickly, usually equity, or sell parts of the company, and  Pay debts without affecting the underlying structure of company

Insolvency versus going concern  Cash flow insolvency sees insolvency as a day to day issue  Balance Sheet insolvency is seen when the Financial statements are constructed 6 monthly or annually when the company, and auditor, needs to evaluate whether the company is a going concern  Can they meet their obligations over the next 12 months?

Early warning signs of insolvency  Red flags in analysis module identify many of the early warning signs of insolvency.  Early warning signs of insolvency can be grouped in two categories  What will management see  What will the Directors see  Management will often see the early warning signs before Directors  This reinforces the need for strong internal systems, reporting channels and a healthy ethical environment that allows staff to bring forward problems in a non threatening manner

Early warning signs of insolvency  Management  Problems selling stock  Problems collecting funds  Slow payment of debts outside usual business terms  Solicitors letters  Issuing post dated cheques  Suppliers insisting on cash-on-delivery terms  Payments to creditors of rounded sums not reconcilable to specific invoices.

Early warning signs of insolvency  Directors  Poor cash flow compared to income  Ongoing losses  Failure to develop business plan  Failure to budget or review expenditure regularly  Failure to forecast cash flow  Overdraft limits reached  Converting overdraft into fixed debt  Changing banks, more stringent lending conditions, higher margins  Board disputes resignations

Early warning signs of insolvency  Proper reporting by management of the early warning signs to the board is essential  The board must determine appropriate reporting so that early warning signs will be reported on.  Reporting should include the early signs seen by management and employees  Otherwise, once the board sees the early warning signs the company is much closer to insolvency.  Early warning signs can become questions and reports required by Directors to avoid insolvency and to alert them to insolvency issues as early as possible.