Most insolvencies can be predicted. An insolvency occurs when a business is unable to pay its debts when they fall due.

The two commonly used tests to determine whether a business is insolvent are the Cash Flow Test and the Balance Sheet Test. Under the cash flow test, a company is insolvent if it can’t pay its debts when they fall due. This is an objective test. The balance sheet test has been the most traditionally used benchmark and looks at total assets and total liabilities. While this is useful, it must be viewed in light of the limitation of balance sheets in that the balance sheet only provides historical value and doesn’t necessarily indicate actual values or an ability to repay debts when they fall due. Better tests may be the use of liquidity ratio such as working capital and quick ratio which matches current assets and current liabilities.

Long before a company actually becomes insolvent, there are signs, early warning signals, that all may not be well. The sooner a problem is identified, the better the chances of recovery.
 
Warning Signs - Insolvency
 
The absence of proper management information systems and lack of planning or control processes are pointers to possible future insolvency. Failure to keep accurate records is often identified as one of the prime causes of business failure.

There are other telling signs of a business in trouble. When stock levels are depleted, payments to creditors are extended beyond normal terms, insurance premiums are not paid, or when BAS returns are not remitted or superannuation payments not made, there are clearly problems. However, this may not be obvious to some small business owners in similar situations as they may be totally unaware, that they are heading for a disaster especially if their record keeping is poor or is not up to date.

If you suspect that your business may be insolvent, you should seek some professional advice and objective diagnosis of your problem is vital.

 

Diagnosis involves determining firstly whether you are actually insolvent or are merely experiencing a temporary liquidity problem. This involves the ability to determine the causes of the causes of the business failure and the extent of the problem. At this stage, depending on the seriousness of your concerns, you may wish to consult your accountant or business adviser. 

To determine whether the business has a viable future you need to look at the causes of the problem, the extent of the insolvency and whether the problem is temporary or permanent. Being in denial will not help your business survive. Survival requires management to discover the causes of a problem and to address them. If you don’t know what is ailing your business, how can you find a cure? Causes of failure may be internal or external, controllable or uncontrollable. Each by itself may not cause the business to fail but the combination of a number of factors may. External causes of insolvency arise outside the business itself and may be due to general economic conditions, industry-wide factors, exchange rate fluctuations obsolescence, changes to the law and so on. These factors may be outside the control of the business but a manager who is aware of them may be able to make changes within the organisation to minimise their effects.

Controllable Problems

Internal causes of insolvency are within the control of management. If these causes are identified in early stages, it may be possible to retrieve the situation by a series of corrective measures such as pricing policies, cost structures, management expertise or experience, quality of staff, staff attitudes, finance, inventory management, plant replacement policies and quality control.
 
Regardless of whether the factors are internal or external, failure to deal with them in the early stages can result in a temporary problem becoming a permanent one. If your business is in trouble and you detect the signs early enough, it will be easier to manage and you may be able to work your way through the problems informally with the assistance of your bank or creditors. However, if a problem is permanent, then informal workouts are generally out of the question and some kind of formal administration may be more appropriate. Conversely, even in situations where minor changes are all that is necessary, if you leave it too late the demise of the business is often the only realistic outcome.