The UK economy remains challenging. Inflation is set to increase, there is a global supply chain crisis and government coronavirus support measures have come to an end.
As a result, the number of UK insolvencies is set to skyrocket in the next 18 months.
If one of your customers or suppliers faces insolvency it could put your business at risk too.
Understanding commercial insolvency and how to minimise the risk of it affecting your business is therefore vital.
In this guide, we’ll cover:
- What is commercial insolvency?
- Why understanding commercial insolvency is important for businesses
- Types of insolvency procedures
- 7 common commercial insolvency questions
- How to check if a company is commercially insolvent
- How to spot corporate insolvency warning signs
- What to do if you have a client that goes insolvent
- Expert opinions on insolvency
- Protect your business with Red Flag Alert
What is commercial insolvency?
Commercial insolvency (sometimes known as corporate insolvency) is when a business cannot meet its financial obligations and repay its debts when they are due. There are two main tests to see if a business is insolvent.
- Cash flow insolvency is when a company cannot pay debts due to insufficient cash flow.
- Balance sheet insolvency is when a company’s liabilities exceed its assets.
The aim of insolvency proceedings is to provide a transparent and fair process that helps a company’s creditors get their money back and where possible, make the business profitable again.
Commercial insolvency is a financial state and not a legal status. This means that an insolvent company doesn’t have to close down and can seek a solution via an insolvency procedure.
Why understanding commercial insolvency is important for businesses
If you are an unsecured trade creditor and one of your customers enters commercial insolvency owing you money, you are unlikely to get it back.
That’s because there is a strict order of priority that decides which of a company’s creditors get paid first when insolvent company assets are sold off. That order is:
- Preferential creditors like salaries and money owed to directors
- Secured creditors with fixed charges; for example, banks
- Creditors with floating charges
- Unsecured creditors—businesses that are owed money on invoices
Once secured and preferential creditors have been paid off, there is rarely any money left for unsecured creditors.
Instead, your business would have to absorb the loss as bad debt.
Types of insolvency procedures
In this section, we’ll take a look at some of the different types of commercial insolvency procedures. We’ll also explain what each one means for you if one of your customers has entered them.
Putting a business into administration stops creditors from taking court action to recover debts. This gives the company time to trade its way out of commercial insolvency.
It puts the company under the management of a professional administrator whose job is to act in the creditors’ best interests.
If a company cannot get out of commercial insolvency the administrator will create a plan to better compensate creditors than they would be if the company was simply wound up.
There are three ways that administrators can be appointed:
- By company directors: If company directors realise that the business is insolvent they may appoint administrators themselves.
- By court order: A creditor can apply to the court to place an insolvent company into administration. This could help them recover the debt owed to them.
- By a floating charge holder: When banks lend to companies they often place floating charges on the company’s property. This allows them to recover funds if the assets are sold during commercial insolvency. Organisations with a floating charge can file a notice to appoint an administrator with a court.
Company Voluntary Arrangement (CVA)
A company voluntary arrangement is when the company arranges a solution with unsecured creditors. This usually involves the company renegotiating its debts and agreeing on a repayment structure while trading.
A company voluntary arrangement needs to be executed through the courts, so it’s a good idea to seek legal advice if one of your clients enters a CVA. You should also be invited to vote on the insolvent company’s proposal. The majority of unsecured creditors need to agree to it for it to be enacted.
If a creditor has a charge over the majority of an insolvent business’s assets it can appoint an official receiver. The official receiver acts in the creditor’s interests to recover as much of the debt for them as possible. This differs from administration, where the primary aim is to pay debts and avoid entering the liquidation process. If an official receiver is called in it usually results in liquidation.
Administrative receivership is becoming less common as it can only be applied to charges placed before 15 September 2003. Charges placed after this date need to be activated via an administrator.
There are two types of liquidation: compulsory and voluntary. Compulsory liquidation is when a company is ordered to close down and its assets are sold to pay creditors. To be liquidated, a company must be unable to pay its financial obligations. It can also be forced into liquidation by a court.
If you are an unsecured creditor, forcing a customer company into liquidity is usually a last resort. There is very little chance that you will get back the money owed. We’ll explain why in the next section.
Another type of liquidation is a company voluntary liquidation (CVL). This is when at least 75% of shareholders vote in favour of liquidation. This is sometimes called a creditors’ voluntary liquidation. In a creditors’ voluntary liquidation, directors of the company in financial distress ask the shareholders to vote to liquidate the company so it can pay its debts.
6 common commercial insolvency questions
Commercial insolvency can be confusing and frustrating for creditors, especially if they have never experienced it before. In this section we aim to answer a few common questions on commercial insolvency.
Why do companies become insolvent?
Commercial insolvency can be caused by a range of factors. Sometimes it is a mixture of several financial difficulties. This could include:
- Inadequate accounting skills
- Increased costs squeezing margins
- Lawsuits or compensation claims eating into reserves
- Loss of business
- Experiencing bad debt after a client becomes insolvent
- Devalued assets
- Too much outstanding debt
What is the commercial insolvency process?
There are two ways that the commercial insolvency process can begin.
- The directors or a creditor appoint an administrator.
- The administrator will be placed in control of the business and will attempt to make it profitable again. All legal action against the business is halted and the company will contact creditors to let them know what is happening. They may also seek to negotiate repayment terms.
- If the administrator decides that the company cannot be rescued, or tries and fails to rescue it, the company enters liquidation.
- The administrator sells off the company assets, repays creditors as much as possible and closes the company.
- A creditor issues a statutory demand against the company via the court.
- If this is upheld and not disputed the company has 21 days to pay their debt.
- If the demand isn’t met the creditor may submit a winding-up-petition to the court.
- If a winding up order is granted the company is liquidated
- A liquidator sells off all the company’s assets, repays creditors and closes the company
What laws govern insolvency in the UK?
In the United Kingdom, insolvency is regulated by the UK Insolvency Act 1986, Section 123. You can read more about the Insolvency Act here. The Insolvency Act covers all matters relating to insolvency and winding up businesses—including unregistered companies and those that are not insolvent—as well as individual insolvency and bankruptcy.
The Insolvency Act also governs the work and qualification of insolvency practitioners and the public administration of insolvency, and can be used to deal with cases of malpractice.
What happens to directors at insolvent companies?
If a company becomes insolvent the directors’ legal position changes. They need to act in the best interests of creditors—not shareholders. If they continue trading insolvently they become personally liable for any additional creditor losses that the business makes. If this happens they can be sued for wrongful trading or subject to director disqualification proceedings.
Can an insolvent company continue trading?
Insolvent companies can continue to trade. But it’s important that directors seek professional insolvency advice and minimise further creditor losses. If they don’t they could become personally liable for any further creditor losses.
A company could be forced into liquidation if a creditor files a winding-up petition with the courts and it is upheld as a winding up order.
What is the difference between insolvency and bankruptcy?
Insolvency is a financial state of being. It is when a company can no longer pay debts when they are due, or when its assets exceed its liabilities.
Bankruptcy is a legal status in which a court decides how a business will pay off its creditors. Compulsory liquidation is a form of company bankruptcy.
You can have an insolvent company that isn’t bankrupt. Administration is a good example of this.
How to check if a company is insolvent
There are two main tests to determine whether a company is insolvent. They are the cash flow test and the balance sheet insolvency test.
Cash flow insolvency test
Testing if a company is cash flow insolvent involves calculating whether a business can pay its debt obligations when they are due. If your customer needs to pay an invoice within 30 days, has no funds and won’t have any cash coming in before the period is up they are likely to be trading insolvently. There is a ‘reasonably near future’ rule which provides some flexibility with the cash flow insolvency test.
The balance sheet insolvency test
The balance sheet insolvency test determines whether the company’s assets are worth less than its liabilities. To do the balance sheet insolvency test you should seek advice from professional insolvency practitioners. If the value of a company’s assets and liabilities are similar it could be an insolvency early warning sign.
A business can be balance sheet insolvent but cash flow solvent if its revenue allows it to meet its financial obligations.
Insolvency scorecards like Red Flag Alert allow you to quickly and accurately assess how much risk a company poses.
Our database consists of over 100 data points on every UK company. Our predictive algorithm uses 15 years of insolvency experience to spot trends and predict which companies will fail.
We rate healthy companies gold, silver and bronze, while companies at risk of insolvency are rated one, two and three red flags.
This allows you to make decisions over whether to extend credit to a business or not.
How to spot insolvency warning signs
Spotting clients at risk of insolvency is hard. It’s important to monitor your clients for insolvency warning signs. Signs that a company faces insolvency include:
- Having statutory demands, winding up petitions and/or county court judgements filed against it.
- It is increasingly unable to pay bills, or there is a deterioration in service quality.
- The directors hold a fixed charge over the company’s assets.
- It is suffering unsecured losses due to a customer being liquidated.
- Failure to file accounts, filing them late or changing its accounting period.
- Poor liquidity.
- No cash reserves.
For more information, read our article on how to spot insolvency warning signs.
What to do if you have a client that goes insolvent
How you deal with an insolvent customer depends on whether they are at risk of insolvency, technically insolvent, entering administration or being liquidated.
Here is an overview of what you should do in each situation.
At risk of insolvency
If the customer isn’t already insolvent but is showing signs that it could be heading that way there are a number of things you can do. These include:
- Propose a repayment plan
- Issue late fees
- Suspend services
- Tighten your credit terms
- Withdraw credit
Repeatedly unable to pay invoices
If the customer is continuously unable to pay their invoices it may be worth taking court action.
For example, if a company owes you more than £750 you may wish to submit a statutory demand. A company that receives a statutory demand has 21 days to pay the debt or reach another agreement. If they don't, their business could be wound up by the court.
The benefit of this approach is that the debtor commits to repaying you. The downside is that the business relationship will be damaged and unlikely to recover.
Furthermore, if the company is wound up they will be unable to pay you and you may not get any money back at all.
Company voluntary arrangement
If a company enters a company voluntary arrangement it will invite you to a creditors’ meeting. Here it will propose an arrangement that you will get to vote on. If the proposal is accepted it becomes legally binding and the creditors retain control of the company.
If your client enters administration any legal action against it will be halted. This means that you won’t be able to pursue statutory demands or CCJs against it.
Contact the administrator and tell them how much you are owed. They can then let you know how to make a claim should the company be liquidated.
It might be worth maintaining good relations with the company directors despite their company’s insolvency. If the business gets back on its feet or the directors start a new company you may be able to keep their business.
A company can be liquidated either voluntarily or compulsorily. In both cases, the company’s assets will be sold off to pay creditors and the business will be closed down.
You should be contacted by the official receiver or a licensed insolvency practitioner, who will explain how you can make a claim. If you don’t hear from them try to get their details一they should be available on the commercially insolvent company’s website.
You can check if a company has entered corporate insolvency proceedings using the Companies House WebCheck service. Or you can visit the government’s corporate Insolvency Service website for more help and information.
Protect your business with Red Flag Alert
Understanding commercial insolvency is vital for company directors, especially during these challenging economic times.
Red Flag Alert allows you to spot the early warning signs among your customers and take proactive action to protect your business from risk.
Our experienced team collects real-time information on every UK company, while our algorithm uses 15 years of data to accurately predict which companies are at risk of corporate insolvency. Our monitoring alerts ensure you know as soon as a company’s financial position changes.
Discover how Red Flag Alert’s experienced team can help you protect your business.