Solvent vs Insolvent Liquidation
Liquidation can be the appropriate route to take in a number of different scenarios, for instance, when a company is struggling with mounting debt and heading towards insolvency. Here, directors frequently make the mistake of continuing to trade, with the intention of guiding their business out of trouble, however, the reality is that this seldom happens. By opting to voluntarily liquidate the company, directors can finally have peace of mind that they will no longer have to deal with unpleasant creditors or stark warnings issued by HMRC. Liquidation provides the opportunity to tie up all loose ends and dissolve the company in other words remove the company from the public register at Companies House, move on and start afresh.
This formal process can also be the answer for directors looking for a way to wind up their solvent company for tax purposes, converting its assets into cash so that the funds can be distributed amongst shareholders tax efficiently. This process is known as a Members’ Voluntary Arrangement (MVA) and, again, it ensures a clean break for all directors/ shareholders.
Let’s take a look at solvent and insolvent liquidation in more detail.
What is solvent and insolvent in accounting?
In accounting “solvent” or “solvency” describes a company that is able to meet its financial obligations in the longer term. Solvency is crucial to trading and staying in business. It’s also a clear indication that the company is able to continue to operate into the foreseeable future.
Whilst cash is the lifeblood of any business and companies clearly need liquidity to thrive, this shouldn’t be confused with a company’s solvency as this relates to the company’s ability to pay its long-term debts, including any interest due.
For a company to be considered solvent, the value of its assets must be higher than the total of its debt obligations. Accountants use ratios to assess a company’s solvency. For instance, the interest coverage ratio divides operating income by interest expense to show whether the company is able to pay the interest on its debt, with a higher result indicating a greater level of solvency.
Accountants also use the debt-to-assets ratio, which divides the company’s debt by the value of its assets to indicate whether a company has taken on too much of a debt burden, with a lower result demonstrating a greater level of solvency.
Solvency ratios can vary depending on the industry in which the business operates. Ratios that indicate a lower solvency than the industry average may suggest that the company is heading for financial problems.
In accounting, insolvency is when the total value of a company’s liabilities exceeds the value of its assets. In this scenario, accountants look at the company’s balance sheet to find out whether the company is “insolvent on the books” when its net worth appears negative. This scenario is also known as technical insolvency.
Insolvency is also known as cash-flow insolvency and this occurs when a company is struggling to make payments to suppliers and/or lenders. That said, they are different as cash-flow insolvency is when a company misses or is unable to service a debt or repay creditors. Actual insolvency is declared exclusively when an accountant looks at the company’s balance sheet regardless of whether it is able to continue to operate.
When a company is struggling and appears to be insolvent on the books, it is likely that disgruntled creditors will force a response. In this situation, the company may attempt to restructure the business to alleviate its debt obligations or may be forced into liquidation by irate creditors via the Court.
Solvent liquidation definition
The term “liquidation” can conjure up images of a struggling business and a negative process. However, some directors will choose liquidation as an efficient way to wind up their company, and here’s why.
In short, solvent means that the assets of the company exceed its debts and liabilities, and that the company is able to pay all of its creditors in full, including interest due, within a 12-month period. A MVL can be used to close down a solvent company. Recent changes to legislation have meant that a MVL process must be used for any final shareholder distribution of funds that exceed £25,000 in order to receive automatic capital tax treatment. This system has replaced a HMRC concession that was used previously to receive the tax benefits.
These tax benefits are the main reason limited companies opt for an MVL. There is also the possibility of receiving Entrepreneurs’ Relief against the funds, which could potentially reduce the tax rate to 10%. This significant tax saving, therefore, usually outweighs the cost of the liquidation process itself.
Insolvent liquidation definition
In contrast, the term insolvent means that a company is unable to meet its liabilities as and when they fall due and its debts exceed its assets. In this scenario, A Creditors’ Voluntary Liquidation (CVL) is a formal liquidation procedure that is used to close down an insolvent company. This is a voluntary process, which is initiated by the company’s directors/shareholders and it involves realising or selling the assets of the company to pay back creditors. This procedure requires the appointment of a licensed Insolvency Practitioner (IP) to manage the process.
Compared with a court-led compulsory liquidation, which is led by a disgruntled creditor, a CVL gives directors more control over the situation as they have the flexibility to decide on the IP, the opportunity to purchase the assets and the goodwill of the company if the directors wish to start afresh with a new trading company.
The rules of bankruptcy also apply to insolvent estates, so let’s consider the following scenario.
Solvent vs insolvent estate
All the money and property owned by an individual, especially at death, is known as his or her estate. A solvent estate is where the total value of the assets exceeds the debts. When the estate is solvent, the executor or personal representative of the deceased will have sufficient funds to pay all the bills the estate owes and once these debts are settled, the executor can then begin to distribute the remaining property as inheritances. The executor should distribute all money and property in line with the terms of the will.
In contrast, an insolvent estate is one where the debts exceed the total value of the estate. If the estate is insolvent, the executor will not have sufficient funds to settle bills. The rules of bankruptcy apply to insolvent estates and in a similar vein to insolvent companies, assets must be sold and creditors must be paid in a specific order of priority. In order to do this, the executor will have to determine which creditors should get paid first and in which order. Once the estate’s funds are depleted, some creditors may not be paid and there will be nothing remaining to distribute as inheritances.
Here is the order of priority for paying creditors from an insolvent estate also known as a hierarchy of payment:
- Secured creditors
- Funeral expenses
- Testamentary expenses (expenses relating to the will)
- Preferential creditors
- Unsecured creditors
- Interest due on unsecured loans
- Deferred debts, for example, between members of the family.
If the executor dealing with the estate pays an inferior debt before a superior one, in this way leaving insufficient funds to cover the superior debt, they could find themselves personally liable for all misdirected monies.
The executor can administer the estate informally outside of the Court or opt to apply for an insolvency administration order. If the person died intestate in other words without a will, the appointed estate administrator can make the petition. Administering the estate under the direction of the Court will provide the executor with certainty, but for the majority of insolvent estates this route is not an option. Once the administration order has been made, the power of the executor is suspended and can only be exercised with the sanction of the Court.
Creditors can also apply for an insolvency administration order, but they must demonstrate that it is “reasonably probable” that the estate is insolvent.
Administering an insolvent estate outside of the Court is typically the method used as it is more cost effective than making repeat applications to the Court for direction, which is also time consuming.In some instances, it may be necessary to appoint an interim receiver to protect the assets of the estate until the petition is heard by the Court.
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