Liquidity test or balance sheet test – that is the question? I contend that you should [almost] always start with the balance sheet.

For many decades there has been a preponderance of judgments focusing on liquidity rather than net assets when assessing a company’s solvency. And that is not surprising when the legislation itself identifies the ability of the company to pay all its debts as and when they fall due as the test.

Although the legislated test is worded slightly differently around the world, the concept is the same. And this is important. The test is used in many situations attempting to redress the unfortunate circumstances of creditor shortfalls.

Very few insolvencies involve a liquidity problem with the entity still enjoying a surplus of assets over liabilities. If there are more liabilities than assets then the company isn’t going to be able to pay all its debts. However, there are a couple of exceptions. The more likely exception is where the company is able to make sufficient surpluses to be able to restore net assets over time. If that is going to be argued, I respectfully suggest the onus of proving its reasonable probability should fall upon the proponent of the argument.

Similarly, if it is suggested that funds could be raised in the form of equity to enable all the debts to be paid when due, the proponent should have the onus of proving the availability of that equity with reasonable probability. It is a rare species who are prepared to invest in an insolvent company by way of equity. However, if such a fanciful idea is entertained, that shifts the focus of the insolvency test away from the balance sheet and back to the cash flow.

The other common assertion is that the company could have borrowed the money. The inescapable problem with that argument is that, although funds have been introduced in order to pay the due debts, a new debt has been created in place of the paid debts. So there then has to be a balance of probability that the new debt can be met when it falls due i.e. borrowing is simply a rearranging of the deck chairs in the context of the solvency test.

All debts means all debts. There has been, in my view, an unhealthy willingness to restrict the discussion on the test to the foreseeable future and with an unnecessary fixation on liquidity. The context must be remembered – the enterprise failed so any consideration about whether restorative profits could have been generated needs to factor in the scenario that actually unfolded i.e. was the scenario that actually occurred a reasonable probability? Also paramount in that context is consideration of the fate of the creditors who have not been paid, irrespective of whether they were incurred at the time of the event under consideration or at the eleventh hour.

There should be no confusion that the first test should almost always be the net assets test. The liquidity test often becomes a distraction because the “all” is overlooked.

Following is an example of how things can become horribly confused. This is not an isolated example of overlooking the importance of the balance sheet when assessing an entity’s solvency. The bank had a $10m facility secured over land and a general security agreement. The assets had a value of about $5m in total and the bank appointed an investigating accountant to prepare a report and then monitor the implementation of the recommendations. The facility was in default of several covenants.   The company had no hope of restoring sufficient profitability to recover so the bank gave the company the ultimatum to sell its assets or the bank would enforce its securities.  The court decided that as the bank had decided to work with the company in order to minimise its loss, and had not called in the facility, then it was able to pay its due debts. However, such a narrow view neglects to take into account the position of the other unpaid creditors, irrespective of when they were incurred. It is those creditors that the legislation is trying to protect.

If there is a deficiency in net assets, the company needs to be able to demonstrate an ability to produce sufficient profitability to restore net assets in a reasonable timeframe, or the company is insolvent.

Keep it simple.

David Blanchett
26 March 2018