The Corporations Act 2001 defines insolvency as a state of being “not solvent” or, more accurately, as the incapacity of a person or entity to be able to pay their debts as and when they become due and payable.
Realistically, insolvency is often preceded by various warning signs well before the technical definition. However, many directors often overlook the common warning signs which can result in businesses continuing to trade while insolvent for extended periods, potentially leading to personal liability. To support company directors and your clients, we have compiled a list of the most common signs of insolvency.
Lack of Working Capital and Inability to Raise Capital
If your company lacks sufficient working capital, it may be unable to meet trading liabilities as they arise, this is a good early indication that you may be heading towards insolvency. Additionally, difficulty in securing further working capital may suggest that credit agencies view your company as unable to meet its financial obligations.
Employee Payment Shortfalls
Failing to pay employees on time or a company being unable to meet employee entitlement obligations, including superannuation, is a clear indicator that a company may be insolvent. Not paying superannuation also comes with the potential for personal liability issues if the Australian Taxation Office “ATO” issues a Director Penalty Notice (“DPN”) for more information on DPNs you can read our article here.
Poor Records Maintenance
Maintaining accurate financial records is essential for understanding a company’s true financial position and is also a legal requirement under the Corporations Act 2001 (“the Act”). Beyond serving as an early warning sign of insolvency, inadequate record keeping can allow a Liquidator or Administrator to presume insolvency, potentially broadening the scope of an insolvent trading claim.
Special Payment Arrangements and Favouring Certain Creditors
Engaging in special payment arrangements or making large round sum payments to satisfy specific creditor demands is an indicator of insolvency. This is especially the case when these payments are being made only to certain creditors and not reconcilable to a specific invoice. Engaging in these types of arrangements also places creditors at risk of having their payments clawed back in a Liquidation due to their preferential nature.
Non-Payment of Statutory Liabilities
Allowing state and federal taxation obligations to enter overdraft is a common way in which companies choose to deal with their cash flow issues. When observed on a long-term ongoing basis and combined with a poor current ratio this is a very strong indicator that a Company is insolvent. Like with superannuation non-payment, allowing statutory liabilities to become overdue also places Director(s) at risk of receiving a DPN from the ATO.
Other Warning Signs
It is important to keep in mind that in the current economic climate there are a variety of external factors that may indicate the potential of insolvency in a Company. These include but are not limited to industry downturn, supply costs, labour costs and regulatory pressures. While some of these and indicators above can be more serious than others, if you have any concerns about the solvency of your Company or client, we recommend contacting our expert team for an obligation free consultation.