Many businesses will find themselves in debt at some point, although in last month’s blog we established that not all debt is bad! What is bad, however, is when the amount of money owed starts to accumulate and you find yourself with cash flow issues. There are many other ways to run into cash flow problems, and when things are consistently negative then it becomes a serious matter. In this article we explain the difference between bankruptcy and insolvency, what to do if you find yourself in either of those situations and how prevention is always better than cure.
Insolvency and bankruptcy: what’s the difference?
Insolvency
Insolvency is a “financial state of being”, used to describe a company’s situation when it can’t pay its debts. This could mean that it can’t pay its bills when they become due or it has more liabilities than assets on its balance sheet (you can understand more about those here).
Limited companies should not continue to trade whilst insolvent. Wrongful trading – whereby an insolvent company “has continued to trade in a way which worsens the position of the creditors that any reasonable director would not have allowed” – is defined in the Insolvency Act 1986. You can read more on the tests for wrongful trading actions at http://www.companyrescue.co.uk/directors-guides-insolvency/wrongful-trading. If wrongful trading is proven then the directors can be made personally liable for the company’s debts from the time they knew their firm was insolvent. It is important to note that wrongful trading is different from fraudulent trading – the latter is the case when it can be proven that directors knowingly carried on trading with no intent to pay their debts.
Bankruptcy
Bankruptcy is a legal declaration of a company’s inability to pay off debts and is one of the most common solutions to insolvency. This, or insolvency, is not to be confused with liquidation; the process by which the business’s assets are audited and sold off, usually to pay its debts.
After a period of time (usually one year after a business has declared itself bankrupt) most of its debts are written off. You can apply for bankruptcy yourself or a creditor can apply for you to become bankrupt if you owe £5,000 or more. A bankruptcy petition is an application to the court for someone’s assets to be taken and sold to pay monies owed.
My company is insolvent – what are my options?
It is not the be all end all if your business becomes insolvent. Here are a few things you can do to allow you to continue trading (rather than entering liquidation):
- Contact all your creditors to see if you can reach an informal agreement (this is often helpful if you’re experiencing temporary financial difficulty)
- Enter into a company voluntary arrangement (a binding agreement which states that a company will pay its creditors – in full or in part – over an agreed period)
- Put the company into administration (by doing this you hand over your company to an insolvency practitioner, or administrator. Their job is to try and stop your company being liquidated. If they can’t they will try and pay as much of your debts as possible from your assets)
You can read more about entering administration here: https://www.gov.uk/put-your-company-into-administration
How to prevent your company from getting into debt
Of course, it would always be preferable to take the necessary precautions to prevent your business from getting into too much bad debt (a bad business debt generally occurs when you owe money to a creditor that you can’t pay – or a debtor owes money to you that they can’t pay).
We carried out a survey with 500 business leaders last year and found that 68% have had to deal with late payments in the past and 53% have had to write off bad debts. Perhaps even more shocking is the fact that the average sum owed to a company in 2015 was £31,901, and that one in four SMEs go bankrupt if the average sum outstanding grows to £50,000 (according to the FSB).
Company Check’s credit reports are one precaution against financial risk; many of our customers use them to measure the health of their own business’ finances. Not only we can provide reports and graphs which plot your assets and liabilities over time, but our Credit Risk score is particular helpful in helping you determine how likely your firm is to become insolvent over the next 12 months.
You can also use the reports to vet potential customers. Looking at a firm’s accounts will give you an indication of its overall financial ‘health’; how much profit it is making and how much debt it is in etc. Alarm bells should be ringing if a company has a higher level of liabilities, compared to assets, a bad credit rating or previous court judgements. If your gut instinct is telling you that the risk is too high, then it’s probably best to walk away.
