Prior to reading this article, please be sure to read the introductory article: Insolvency and Bankruptcy – Know the Difference as it is a great lead in to the more sophisticated information provided here. There are several links throughout this article to assist the reader in understanding other elements of insolvency. If you are having trouble understanding some of the formulas, please refer to the material linked to help you.
This article will first teach you about the basic tools used to detect insolvency. Other articles on this site will explain this in more detail using trend lines to evaluate a company’s ability to pay its current liabilities. Finally, I will explain some tricks and nuances related to insolvency so that you have a well informed position of knowledge related to insolvency.
Insolvency – Basic Tools of Detection
There is one tenet of insolvency the reader must remember and keep in their mind at all times. Insolvency is an extended time period and not a single moment in time. In effect, it takes several months to become insolvent and rarely does it exist for a short duration, such as one or two days. Again, insolvency extends over a long period of time, at least two months and often over many months (more than six). Given this, the tools to test for insolvency must be exercised over time, and not for a single day or a few days.
An illustration is an excellent way to make this point.
Remember, insolvency means that the company has an inability or trouble meeting all of their obligations. Obligations consist of current liabilities and payroll. Obviously, it takes cash to pay the liabilities. Look at this simple balance sheet.
Cash in the Bank $141,205
Total Current Assets $351,405
Fixed Assets 300,000
Total Assets $651,405
Accounts Payable $175,110
Payroll Due on Friday 65,291
Total Current Liabilities $240,401
Long-Term Debt 185,000
Total Liabilities & Equity $651,405
It is apparent that XYZ cannot pay their current liabilities including payroll. There simply isn’t enough cash in the bank to meet the obligation. This is a single moment in time, it looks bad doesn’t it? Well, let’s modify this a little. Assume that accounts payable are not due immediately but are due at the end of January. Only the payroll is due immediately. Can XYZ meet their obligation in the upcoming week? Yes, they can. $141,205 is more than enough to pay the staff on Friday. Is XYZ insolvent? It’s hard to tell at this point, so having an understanding of the other factors can greatly impact your thinking. Questions to would ask include:
- Did the company recently make dividend payments to the owner(s)?
- Will the inventory turn over during the month of January?
- Since there is no accounts receivable, is it safe to assume the inventory is paid in cash at the point of sale?
- Is there a line of credit available to utilize in case cash is needed?
- Do the payables have longer terms, such as due in several months?
- Is this company a seasonal operation?
The last question is interesting, because if this is a summertime operation, i.e. the company sells mulch; then I might be concerned about solvency. But let’s say its a government contractor in Minnesota that provides road salt for various parties that must pay immediately upon purchase.
A preliminary test to identify insolvency is the current ratio. It is simply all current assets divided by all current liabilities. With the above example the current ratio is:
XYZ’s Current Ratio = $351,405 = 1.46:1
As long as the current ratio is not less than 1:1, it means the company is solvent based on this ratio. However, notice that it is an instant ratio, just for this one moment in time. To better evaluate the company, the ratio should be reviewed for each month ending for the prior six or more months to get a line graph of the ability to pay its current liabilities. Naturally, the higher the result, the better off the company is to meet its obligations. Ideally, ratios of 3:1 or more are best.
There is a drawback to using the current ratio and its the inclusion of inventory in the numerator. Often inventory is a significant sum and it can leverage the ratio higher. Therefore, another ratio is considered superior. The quick ratio which excludes inventory really identifies the ability to pay current obligations immediately. For XYZ Company the quick ratio is $141,205 divided by liabilities of $240,401 or .588 to 1. This is a big red flag for just about any company out there. Ideally, quick ratios of 1.5 or higher are good; over 3:1 is coveted.
As with the current ratio, this ratio should be plotted over several months to identify a trend line.
To augment the above two ratios, other ratios will help to identify cash flow skills including the inventory turnover ratio, the accounts receivable turnover ratio and finally the cash ratio. The cash ratio is even more restrictive than the quick ratio as it only includes cash in the numerator and excludes all other current assets. With really small businesses, this ratio is best but again, it is easily manipulated as it only tells the story on that day.
Finally, the owner/manager will want to review the cash flows statement, specifically the cash flows from operations section to confirm the operations ability to earn cash and how the cash is utilized throughout the statement’s time period.
If there is one thing learned from this section, you need to remember this:
When using any ratio, all data points should come from multiple time periods to identify a trend line and not just a moment in the life of the operation.
The next section will help you to understand this trend line concept more clearly.
Insolvency – See the Whole Picture
Although the various ratios are helpful in identifying the trend line of cash status, the best tool to evaluate insolvency is looking at the whole picture.
A novice entrepreneur will misunderstand what cash is all about. In your more successful operations, the owners purposely keep the cash position low. As he company earns the cash via profits, the cash is distributed to the owners via dividends, draws or distributions depending on the nature of the company. Review the equity section, specifically the debits related to payments made to the ownership. If this number is high and occurs regularly, it is a key sign the company is a cash cow and is working well. Here insolvency is not an issue as the owners can easily put cash back into the company at a given moment’s notice.
Other important points of interest include:
- Cash Outlays for Fixed Assets
- Principal Payments on Long-Term Debt
- Status of Tax Obligations
- Industry Standards
All of these impact the picture of insolvency. For example, those involved in real estate especially housing, it is not uncommon to have low ratios and sometimes very extreme ratios due to debt issues. When an apartment complex is restructuring its debt, the ratios can get wonky to say the least. Those businesses in the service industry will also have odd ratios because there is very little inventory involved. For them, the accounts receivable turnover ratio becomes the primary ratio to evaluate the ability to have cash flow and of course meet the current obligations. Thus it is important to understand the industry while detecting insolvency.
One last helpful hint, look at the accounts payable aging report. Is this value increasing over time? Is it shifting towards a higher average age? This is a key sign of inability to pay current obligations and a good source of understanding management’s overall ability to generate cash from sales.
Summary – Insolvency Detection
Notice in the above sections, the focus is on the balance sheet and not the income statement. Insolvency is a balance sheet issue. The income statement only comes into play to confirm profitability. Losses over several periods will eat into the cash position thus affecting the ratios above. But in general, stay focused on the balance sheet, utilize the liquidity ratios and evaluate insolvency over time. ACT ON KNOWLEDGE.