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Solvency is Critical - But What Is It and What Does it Mean for You?

Solvency is an everyday issue for ALL businesses because it can affect you even if you don't have any outstanding bills or other debts. Here are a few ways the solvency rules can affect you irrespective of your trading performance or business structure.
  1. The Corporations Act places an obligation on company directors to pass appropriate annual solvency resolutions within a strict timeframe. Failure to comply carries possible criminal consequences - do you know when you prepared your last solvency resolution?
  2. You may inadvertently take on the debts of your business if you trade while insolvent. The consequences of this can be financially devastating - especially if you have taken good advice and structured your business appropriately to protect your family home, super fund, and luxury yacht.
  3. Company directors can become personally liable for some tax debt including PAYG and GST - But there are ways to limit that personal exposure and they are relatively straight forward to achieve.

Why You Need to Take Advice

The simple answer is to save you money, heartache, and a criminal conviction!

The Technical Stuff

Background

Section 347A of the Corporations Act says that a company must pass a solvency resolution within 2 months of each review date of the company. The review date is simply the anniversary date of when the company was originally established. Failure to comply with this provision results in an offence which carries with it strict liability which is defined in section 6.1 of the Criminal Code Act.

A solvency resolution means a resolution by the directors of a company as to whether or not, in their opinion, there are reasonable grounds to believe that the company will be able to pay its debts as and when they become due and payable (section 10 of the Corporations Act). It is a cashflow test, not a balance sheet test.

If the company is unable to pass a solvency resolution, then the company must notify the Australian Securities & Investments Commission (ASIC) within 7 days of passing a negative solvency resolution. Again strict liability applies to an offence under this provision.

It should be noted that under section 347C of the Corporations Act that the payment of the review fee to ASIC is taken to be a representation by the directors that the company is solvent. It should be noted that payment of the fee does not absolve the company from making out a solvency resolution as required by section 347A.

So What are the Signs of Insolvency?

The Courts frequently assess whether or not a company or individual is insolvent and if so, when that insolvency started and when various stakeholders should have suspected it. This usually occurs when a liquidator commences a recovery action. It is also a critical factor for directors, when liquidators or creditors commence recovery actions for damages arising from insolvent trading or related claims.
Some judges have developed a schedule of 'indicators of insolvency' that are considered in the claim. These should be readily and frequently used by all parties concerned when considering whether a person or business is insolvent. This issue was discussed in detail in ASIC v Plymin (2003) 46 ACSR 126, with the Judge referring to a checklist of 14 indicators of insolvency.

These indicators were identified as the following:

  • Continuing losses
  • Liquidity ratio below 1
  • Overdue Commonwealth & State taxes
  • Poor relationship with present bank including inability to borrow additional funds
  • No access to alternative finance
  • Inability to raise further equity capital
  • Supplier placing the debtor on COD terms, other otherwise demanding special payments before resuming supply
  • Creditors unpaid outside trading terms
  • Issuing of post dated cheques
  • Dishonoured cheques
  • Special arrangements with selected creditors
  • Solicitors' letter, summons(es), judgments or warrants issued against the company
  • Payments to creditors of rounded figures, which are irreconcilable to specific invoices
  • Inability to produce timely and accurate financial information to display the company's trading performance and financial position, and make reliable forecasts.

Other practical signs that we have noticed over time include:

Sign

Issue:

Creditors

  • Trade creditors not paid on time
  • Lease payments and other creditors not paid on time
  • Delayed employee superannuation contributions
  • Delayed or missed tax payments
  • Suppliers ceased supply or on cash-on-delivery (COD) terms
  • Payment arrangements with selected creditors or payments made in round dollars that are not reconcilable to specific invoices
  • Increased level of complaints or queries raised with suppliers
  • Legal action initiated

Debtors

  • Debtors ledger not reviewed regularly to determine whether debtors are taking longer to pay (possibly bad debts) or are reducing the amount of their purchases
  • Trade terms are too lenient
  • Problems selling stock
  • Significant offsets between debtors who are also creditors
  • Factoring or discounting to obtain 'instant cash'

Bank/Loan Facilities

  • Exceeding overdraft limit or constantly fully drawn
  • Not complying with loan terms and conditions
  • Opening alternate bank accounts
  • Change of banks
  • Lender or increased monitoring/involvement by financier

Cheques and Electronic Banking

  • Cheques returned unpaid
  • Cheques drawn but not presented to creditors
  • Issuing post dated cheques or  dishonouring cheques
  • Withholding authorized electronic payments

Financial Accounts

  • Incomplete financial records or disorganized internal accounting procedures
  • Not enough working capital
  • Too much money is tied up in work-in-progress, debtors or stock
  • Actual trading results are considerably outside budgets/forecasts
  • Budgets/forecasts are not prepared (weekly or monthly) or do not reflect positive cashflow going forward

Employees

  • Union problems and poor employee relations
  • Employee entitlements cannot be funded
  • Transfer of employees to a new entity
  • High turnover

Management

               
  • Lack of relevant skills & experience
  • High turnover
  • Does not conduct walk throughs of the business premises to check for safety issues, team morale, efficiency measures etc
  • An expectation that the 'next' big job/sale/contract will save the company

Disputes

  • Internal – family, shareholders, directors, key employees
  • External – suppliers, debtors, banks other financiers, statutory authorities

Risk Management

  • Insurance cover inadequate and/or premiums in arrears
  • OH & S requirements not satisfied
  • Dependence on one client to generate majority of income
  • Highly sensitive to movements in foreign exchange rates, commodity prices or interest rates
  • Declining industry or high level of competition

What to do if your company is insolvent?

If your company is insolvent, do not allow the company to incur further debt.

An understanding of the financial position of your company only when you sign off on the annual financial statements is insufficient. You need to be constantly aware of your company's financial position. Various penalties including jail terms can be applied.  Unless it is possible to restructure, refinance or obtain equity funding to recapitalise the company, generally your options are to appoint a voluntary administrator or liquidator.

So what do I need to do now?

When a business is in the eye of the storm, the warning signs of an impending crisis may not always be obvious to those charged with overseeing the management and operations or their external advisors. There are a range of indicators to potential insolvency that, if identified early by an advisor or business management, can provide the opportunity to avoid business failure.

We offer a cost effective solvency assessment. Save yourself further worry and contact us now.

If you have any questions or concerns regarding your company, then please call our business improvement team today or 07 5439 1600, email us on support@completebusiness.com.au to request a Free Guide to Company Directors on your Duty to Prevent Insolvent Trading, or click the following to make an appointment to see one of our experts: