Your Guide to Understanding Insolvency
Insolvency is when a company or individual are under a certain level of financial stress that they can no longer meet its financial commitments. In Australia, insolvent trading is illegal as per the Corporations Act. There are serious penalties for trading insolvent including circumstances where company directors may be personally liable. If you think your business may no longer be solvent, it is essential to both understand the different options available and seek professional advice.
What are the indicators of Insolvency?
There is a long list of factors which are indicators of insolvency, the main being unable to pay debts as they fall due. In many instances, businesses may appear to be financially stable when they are in fact trading insolvent. Here are some common indicators that a business is insolvent, or on the verge of corporate insolvency.
- Company debts outweigh assets.
- Assets have been sold off.
- Liquidity ratio below 1 – insufficient current assets to meet current liabilities when payable.
- Declining profit margins.
- Loss of staff due to instability.
- Payments to creditors that are not reconcilable.
- Special arrangements and payment plans with creditors.
- Legal proceedings against the company.
- Continuing losses.
- Unpaid creditors.
- Struggling to improve your cash flow
- Overdue taxes.
- Inability to create accurate reports and make reliable forecasts.
- Confusion between personal and business finances.
- Errors in paying employees
- Non-reconcilable electronic transfers.
- No access to alternative finance.
- Inability to raise further equity capital.
- Unable to borrow further funds from current bank.
What are the different types of Insolvency?
The options available differ for companies and individuals. In relation to corporate insolvency, the most common procedures are liquidation, voluntary administration, and receivership. For individuals, bankruptcy and personal insolvency agreements are the most viable options.
Is the process of winding up a company that is unable to meet its financial commitments and has been trading whilst insolvent. During this process, a registered liquidator assumes control of the company so that it can be wound up and dissolved in an orderly manner while meeting all legal requirements. The appointment of a liquidator can occur in several ways:
- Company shareholders decide to liquidate the company (Creditors Voluntary Liquidation)
- Creditors vote for a company to enter liquidation following a voluntary administration or a terminated Deed of Company Agreement (DOCA)
- Court appointed.
The liquidator will then begin the process which includes investigating company affairs, provide a detailed report, distribute any company assets accordingly, and deregister the company.
In contrast to liquidation, voluntary administration does not automatically mean the end of the road for a company. In fact, it could be the difference between saving a company or being forced to liquidate. The purpose of this process is to provide breathing space, assess all available options, and determine the ideal path for the company moving forward.
Once appointed, an administrator will relieve the company directors of their duties and begin the process of providing an in-depth report to creditors. The report will outline critical information on the company assets, operational management, and current financial circumstances. These findings along with recommendations will be presented to the company creditors who will then vote on one of the following outcomes:
- Return control of the company to its directors.
- Approve a DOCA which will specifically outline how debts are to be repaid, or
- Appoint a liquidator and begin the process of winding up the company.
This is the process where a secured creditor (most often a bank) or the court place a company into receivership for the purpose of repaying its debts. The receiver will then:
- Protect, collect, and sell some or all the company’s assets which may also include the business itself.
- Distribute all proceeds in priority order as per legislation.
- It is important to note that a company in receivership may also have a liquidator or administrator appointed.
Read more about corporate insolvency options.
If you are struggling to make ends meet, it is time to become familiar with your options and aware of potential consequences if you trade insolvent. The Bankruptcy Act 1966 states that there are four options for personal insolvency. They are:
Temporary Debt Protection (TDP)
Provides individuals with protection from unsecured creditors initiating action for a period of 21 days. This relief is so that you can seek advice and how best to proceed.
Releases you from most debts, provides relief and allows you to make a fresh start. Bankruptcy normally last for 3 years and 1 day. Prior to declaring bankrupt, it is important to be aware of potential consequences. Bankruptcy may affect your future income, may not release you from all debts, and may hinder your ability to travel overseas.
A binding agreement between a creditor and yourself that outlines how a debt is to be settled. It defines a percentage of income that is to be to a debt agreement administrator, who will subsequently deal with creditors.
Personal Insolvency Agreements (PIA)
This is an arrangement entered into directly with a creditor. It states how you will repay the debts with no income, asset or debt limits involved in PIA’s.
What does insolvency mean for a company?
There is a false perception that insolvency means that a company must instantly begin to wind up its operations. This is not necessarily the case. What the directors of a company must do is explore the most appropriate options available to the company.
In the case of receivership, the fate of the company is no longer in the hands of the directors. Therefore, it is important for directors to explore options such as administration which are designed to provide companies with the time required to evaluate their position. The effective implementation of a restructure and turnaround may allow the company to regain financial prosperity. If the prospects of recovery are unrealistic, then the process of liquidation shall commence.
Insolvency is an area of law which is constantly evolving. This has resulted in the creation and alteration of several key insolvency processes including:
It is a shortened version of the Creditor's Voluntary Liquidation (CVL) which can be accessed by businesses that have liabilities of less than $1 million. The process is significantly faster than a normal CVL at provides a more cost-effective methods for businesses to liquidate.
Eligible small businesses can now work with a small business restructuring practitioner to develop and propose a debt restructuring plan. This allows the directors to remain in control of the business while the restructuring plan is being developed.
These provisions were introduced to encourage directors to seek professional advice to determine the best outcome for stakeholders and mitigate risk, whilst helping their companies trade out of financial difficulty. They prevent directors from resorting to administration or liquidation too quickly and provide the breathing space required to maximise the chance of recovery.
Insolvency vs Liquidation
Despite being closely related, insolvency and liquidation are not one and the same. Insolvency is a financial state of being, where are company is unable to meet its financial obligation and pay its debt when they are due. In comparison, liquidation is the process of dissolving a company. It should be noted that a company in liquidation is not necessarily insolvent. There are circumstances where a solvent company moves into liquidation, the most common of which is when the owner is retiring and there is nobody to take over.
What are the key pieces of insolvency law?
How will insolvency affect me
This can be a complicated answer and one that depends on several factors. The response will depend on whether you are a director, individual business owner, creditor, investor, shareholder, or employee. It is essential for all parties to be aware of their rights and obligations when it comes to insolvency, many of which have been outlined above. Be sure to explore insolvency legislation and information provided by ASIC. Another great reference is our Complete Guide to Business Liquidation.
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