What are balance sheet tests?

A rather wide question. In the context of insolvency, a balance sheet is deemed to be insolvent if it shows negative shareholders’ funds. This situation usually arises out of continued loss making activity. However, a company can have positive shareholders’ funds and still be technically insolvent. This latter situation usually arises where a company has significant fixed assets supporting its balance sheet, i.e. freehold property, plant and machinery etc, although its current assets, i.e. the assets that it uses to trade with on a daily basis being stocks, debtors etc, are less than its current liabilities, i.e. the amounts it owes to its suppliers.

What is balance sheet insolvency?

 
The definition of insolvency is “the inability to discharge your liabilities as and when they fall due”.

To demonstrate this, we have set out below an example of a balance sheet, that, whilst showing the company to have positive shareholders’ funds, on a technical basis, is actually insolvent.
 

Fixed assets £000 £000
Freehold property   860
Plant & machinery   390
Current Assets  
Stock & WIP 540  
Debtors 430  
Total current assets 970  
Creditors less 1 year (1530)  
Net current liabilities   (560)
Net assets   690
Share Capital   1
Profit & loss account   689
Shareholder’s funds   690

 

What are cash flow tests?

This is slightly easier to explain and to some degree follows the premise described above. Cash flows are perhaps more important than the traditional profit and loss statement, given that without the ability to pay suppliers, most company’s life’s will be fairly short. Cash flow is the absolute heart of any business. There is little point in making paper profits, if your customers/clients are not paying on time and causing you problems with paying your suppliers. A sale with a decent margin is only of real value to you once you have been paid. Debtors on the balance sheet do not pay the bills – as is evidenced by the balance sheet above.

Control over cash flow is absolutely critical if you are to manage your company’s finances effectively. It is fairly important therefore to run and regularly update a cash flow model. This doesn’t have to be complicated – all you really need is to input forecast sales with the timing of forecast receipts and against that enter known payments due.

We have a separate page dealing with modelling cash flow – please see our article: 7 Steps to starting your business on firm financial foundations.

A simple cash flow forecast will highlight when you may have a problem in paying suppliers on time. None of us like to consider bad news, but you are much better off being made aware of a potential problem at as early a stage as possible, in order that you may then have more time to try and find a solution to the problem.

 

Balance Sheet Test