What is insolvency?

Insolvency is defined under Section 123 of the Insolvency Act 1986 and is reproduced in detail below.

Understanding the technical definition of Insolvency is only the beginning of getting to grips with its impact on a charity or not for profit organisation and its trustees/management team or committee members.

The point of Insolvency is unfortunately often not black and white, nor is it set in stone thanks to continually changing legal precedents through the courts. However, whilst there will be an element of grey, a charity or not for profit organisation is definitely insolvent at the point where its debts cannot be paid in full.

The ‘tests of Insolvency’ as they are often referred to are the Cashflow test and the Balance Sheet test.

The Cashflow Test is about being able to pay liabilities when they fall due – e.g. are suppliers paid or HMRC tax liabilities paid on time? Does the charity have sufficient short term resources to deal with its impending liabilities? If the answers are no then the organisation is potentially Insolvent.

The Balance Sheet Test compares all existing assets against all existing and potential liabilities as at today’s date, not the date of the last available annual or interim accounts. All existing and potential liabilities includes those known to exist and those that might arise as a result of any current circumstances that exist – e.g. damages or negligence claims for contracts terminated early, redundancy and notice pay costs of existing employees, etc.

Most trustees do not take into account potential liabilities such as the costs of employment severance if the charity had to close. However, when all of these are taken into account it can have a dramatic impact on financial position, turning many seemingly solvent organisations into insolvent ones.

At the point of Insolvency being reached it is very important that advice is sought because should the organisation subsequently enter into any formal insolvency process the actions of the trustees from the point of Insolvency onwards will be scrutinised.

There are other indicators of potential insolvency that can be found here.

Section 123 of the Insolvency Act 1986 defines Insolvency (a position where debts cannot be paid in full) as:

  • the company has not paid, secured or settled a claim for a sum due to a creditor exceeding £750 within three months of having been served with a statutory demand;
  • a creditor has attempted an enforcement process against the company in respect of a debt without success;
  • it is proven to the satisfaction of the court that the company is unable to pay its debts as they fall due (cash flow test);
  • it is proven to the satisfaction of the court that the value of the company’s assets is less than the amount of its liabilities, taking into account contingent and prospective liabilities (balance sheet test).