If you’re running a company in Australia, you’ve likely come across the term insolvency. While the concept might spark panic in the business world, understanding it is essential, both when it comes to your own business and that of the people you deal with.

This guide breaks down what insolvency means in Australia, how it’s assessed, and the key indicators that a company might be heading down that path.

When Insolvency Becomes Relevant in Australian Business Law

Insolvency is the financial state where a business or individual cannot meet its debts as they fall due. It should be distinguished from short term cash flow issues, or temporary illiquidity, neither of which are quite the same thing (though the lines can get a bit blurry sometimes).

For Australian companies, insolvency is a critical issue because it triggers serious legal implications under corporate law. Specifically, directors of insolvent companies face legal duties to avoid trading while insolvent. Breaching these obligations can lead to personal liabilities, fines, and disqualifications.

Similarly, dealing with companies that you know to be insolvent can expose you to unfair preference claims, clawback provisions, and various attacks from liquidators once the company in question goes under.

This means recognising insolvency early isn’t just about protecting your company’s reputation or avoiding creditors knocking at your door. It’s also about safeguarding directors from legal risks and ensuring the business can explore viable recovery options where possible.

Section 95A of the Corporations Act

The definition of insolvency under Australian law is outlined in section 95A of the Corporations Act 2001, which states:

“A person is solvent if, and only if, the person is able to pay all the person’s debts, as and when they become due and payable. A person who is not solvent is insolvent.”

To put it simply, the ability to consistently pay debts on time is what separates solvent businesses from insolvent ones. While straightforward on paper, determining insolvency in practice typically requires analysis through specific financial tests, which we’ll cover next.

The Cash Flow Test vs the Balance Sheet Test

Two primary tests are used to assess insolvency:

The Cash Flow Test

This is the preferred method for assessing insolvency, as it provides a clear picture of whether a company can meet its short-term obligations using available cash or liquid assets. Essentially, if a business doesn’t have enough cash to pay its debts as they’re due, it fails the cash flow test.

Why is this test preferred? Because a business could have valuable physical assets (like real estate or equipment) but still struggle to pay suppliers or meet tax obligations due to a lack of liquidity. Insolvency is about timing, not just total assets and liabilities.

The Balance Sheet Test

This test examines whether the total value of a company’s assets exceeds its liabilities. While useful for understanding overall financial health, it’s less effective for assessing solvency because fixed assets like buildings or machinery may not be immediately converted into cash when debts are due.

For example, a company might show a healthy balance sheet while still failing the cash flow test due to delayed invoice payments or poor cash management.

Indicators of Insolvency

There are no hard and fast rules about when a company is “insolvent”. Instead, the Courts have developed a series of indicators – red flags if you will – that might tend to suggest a company is at risk of being found to be insolvent.

Recognising insolvency in its early stages can make the difference between recovery and collapse. Here are some common warning signs that indicate a business might be on the brink of insolvency:

1. Continuing Losses

Regular financial losses can erode cash reserves quickly. A business that fails to turn a profit over multiple periods might find itself unable to sustain operations.

2. Liquidity Ratios Below 1

A liquidity ratio below 1 (when current liabilities exceed current assets) suggests the business lacks sufficient resources to meet its short-term obligations. This is an early red flag for potential insolvency, despite our comments above about a preference for the cash flow test in terms of the legal question to be answered.

3. Unpaid Creditors Outside Terms

If creditors go unpaid for extended periods, it’s a strong indication that a business doesn’t have enough working capital to cover its debts.

4. Solicitor’s Letters or Legal Demands

Receiving formal payment demands, legal threats, or summonses from creditors signals escalating pressure that shouldn’t be ignored.

5. Dishonoured Cheques

If you still write cheques, then consistently issuing dishonoured cheques, whether intentional or due to insufficient funds, points to cash flow issues and indicates insolvency risk.

6. Special Payment Arrangements

Resorting to payment plans or requests for postponed settlements with creditors shows the company is struggling to meet its obligations under normal terms.

7. Suppliers Demanding Cash on Delivery (COD)

Switching to COD terms or encountering restrictive trade conditions from suppliers suggests they’ve lost trust in the business’s ability to pay.

8. Overdue Tax Obligations

Failing to meet tax obligations, like GST or employee superannuation, is a strong sign of financial stress. These debts often accumulate when businesses prioritise cash flow over compliance.

9. Lack of Access to Finance

An inability to secure loans, credit, or funding from banks, shareholders, or related parties typically indicates other institutions see your business as too high-risk.

What to Do If You Suspect Insolvency

If one or more of the above indicators apply to your business or someone you are dealing with, it’s time to take immediate and measured action.

Here’s what you should consider if it’s your business:

• Seek Professional Advice: Consult with an insolvency practitioner or financial advisor to understand your options. Early intervention increases the chances of a positive outcome.
• Evaluate Your Cash Flow: Take control of your cash flow by reviewing payment schedules and cutting non-essential expenses.
• Communicate with Creditors: Proactively reach out to creditors and explore repayment arrangements where possible.
• Consider Legal Steps: Depending on your situation, voluntary administration or restructuring may be worth exploring to give your business the opportunity to recover.

If you’re dealing with a company that you suspect might be insolvent, you should similarly take pause and consider your options. You might be able to protect your position through proactive steps and minimise any exposure to a future liquidator, rather than just waiting for the inevitable.

Finally, if you’re dealing with a company IN external administration, then you need to understand who you are dealing with and what that means for any commercial arrangements on foot.

Insolvency Is Not (always) the End

For Australian companies, insolvency doesn’t have to mean the absolute end. By recognising the warning signs, conducting regular financial health checks, and seeking professional advice early, businesses can explore recovery strategies to stay afloat.

The key is to act fast. If you’re unsure about your financial position, start by evaluating your cash flow and consulting with an expert. Waiting for the problem to escalate will only limit your options and increase potential risks.