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.
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.
UK Wide Support for Businesses from our Offices in London & Nottingham
If you are experiencing cash flow problems, contact us today. We will provide free advice and a no obligation consultation. Call or fill in our enquiry form and one of our licensed insolvency practitioners will get in touch with you within 24 hours.
We have offices in London, Nottingham and Derby, so we are well placed to support businesses UK wide. We are happy to travel to meet you at a convenient location.
Contact details for London Businesses: Insolvency Advice and Services
Contact details for Nottingham Businesses: Insolvency Advice and Services
Contact details for Derby Businesses: Insolvency Advice and Services
FAQs
Both cash flow and balance sheet insolvency tests are important to assess a company's financial health. There are a couple of key differences between the pair: Balance sheet insolvency compares assets and liabilities. Cash flow insolvency compares available cash flow to meet outgoings on time.
What is the balance sheet test and cash flow test? ›
The cash-flow test considers the ability of a company to pay its debts (or liquidate assets fast enough to satisfy its debts) as they become due and payable. The balance-sheet test assesses the solvency of a company by assessing its total external liabilities against the total value of its assets.
What is a balance sheet test? ›
The balance sheet test looks at all of your company's assets including stock, your debtor book, cash, and any unencumbered property, vehicles and machinery.
What is cash flow and balance sheet? ›
The balance sheet shows a snapshot of the assets and liabilities for the period, but it does not show the company's activity during the period, such as revenue, expenses, nor the amount of cash spent. The cash activities are instead, recorded on the cash flow statement.
What is a cash flow test? ›
The cash-flow test assesses the ability of a company to pay its debts (or sell its assets fast enough to pay its debts) as they become due and payable.
What comes first, balance sheet or cash flow? ›
Key Highlights. The three core financial statements are 1) the income statement, 2) the balance sheet, and 3) the cash flow statement. These three financial statements are intricately linked to one another. Analyzing these three financial statements is one of the key steps when creating a financial model.
How to tell if a company is profitable from a balance sheet? ›
The two most important aspects of profitability are income and expenses. By subtracting expenses from income, you can measure your business's profitability.
What is an example of a cash flow? ›
Examples of operating cash flows include sales of goods and services, salary payments, rent payments, and income tax payments.
What is the difference between P&L balance sheet and cash flow statement? ›
The main difference between a profit and loss statement and a cash flow statement is that a profit and loss statement measures the profitability of the business model while a cash flow statement shows where your money is coming from, where it's going, and how much cash you actually have on hand at a given point in time ...
Is balance sheet insolvency bad? ›
It signals financial distress and poses risks to creditors, potentially leading to bankruptcy or restructuring. Understanding and addressing balance sheet insolvency is critical for a company's survival and financial stability.
While it's also important to look at business profitability on the income statement, cash flow analysis offers critical information on the financial health of a company. It tells you if cash inflows are coming from sales, loans, or investors, and similar information about outflows.
Is cash flow good or bad? ›
Cash flow analysis examines the cash that flows into and out of a company—where it comes from, what it goes to, and what's left over. Consistent positive cash flow signals financial stability, while ongoing negative cash flow could indicate financial trouble.
What is the difference between a personal balance sheet and a cash flow statement? ›
The personal cash flow statement measures your cash inflows or money you earn and your cash outflows or money you spend. This determines if you have a positive or negative net cash flow. A personal balance sheet summarizes your assets and liabilities to calculate your net worth.
What is balance sheet assessment? ›
This financial statement lists everything a company owns and all of its debt. A company will be able to quickly assess whether it has borrowed too much money, whether the assets it owns are not liquid enough, or whether it has enough cash on hand to meet current demands. Balance sheets are also used to secure capital.
What is included in testing for the balance sheet? ›
The strength of a company's balance sheet can be evaluated by three broad categories of investment-quality measurements: working capital, or short-term liquidity, asset performance, and capitalization structure. Capitalization structure is the amount of debt versus equity that a company has on its balance sheet.
