Distress & Turnarounds

The Two Insolvency Tests

Insolvency is not a feeling or a bank balance. It is two legal tests, each with its own evidence — and a third one that quietly decides whether a dividend gets clawed back years later.

  • Advanced
  • 8 min total
  • 12 chapters

What decision this helps you make: Whether the company you are running, lending to, or buying from is insolvent today — and what duties, risks, and reversible transactions that answer switches on.

What this topic is

A company is insolvent when it fails either the balance-sheet test (liabilities, fairly valued and including contingent ones, exceed assets) or the cash-flow test (it cannot pay its debts as they fall due). The tests are independent: failing either one is enough, and a company can comfortably pass one while failing the other.

Why it matters

Insolvency is the switch that changes the rules. It shifts who directors are effectively working for, it starts the clock on transactions that can be unwound years later, it turns ordinary payments into recoverable preferences, and it converts a personal guarantee from paperwork into a claim against a house. Knowing which test you are failing tells you which of those risks is live.

Who should learn it

Directors and officers of businesses under strain, lenders and their advisers, buyers of distressed assets, and anyone who signs a solvency certificate without reading it.

What you will understand

  • How each test is actually applied, with the evidence courts look for
  • Why fair valuation, not book value, decides the balance-sheet test
  • The third test — unreasonably small capital — and why it kills dividend recapitalizations
  • What changes the day insolvency arrives: duties, clawbacks, and the value of a guarantee

Prerequisites

Common misconception

"We have positive net assets, so we are solvent." Two problems. First, the balance-sheet test uses fair value, not book value, and counts contingent and prospective liabilities that never appear on the face of a balance sheet. Second, it is not the only test — a company with strong net assets that cannot make Friday's payroll is insolvent on the cash-flow test, and that is the test creditors and courts reach for first because it is the one they can prove.