Solvency and liquidity: the acid test for companies

The Companies Act 2008 reflects a shift away from the principle of maintaining the capital structure, to maintaining the solvency and liquidity of the enterprise, when compared to the previous 1973 Act.

Previously, companies were:

  • not allowed to provide financial assistance for the purchase or subscription of its shares,
  • precluded from purchasing its own shares, and
  • not able to make payments to its members, other than by way of dividends paid from company profits.

Solvency and liquidity

The responsibility for applying the solvency and liquidity test is that of the board of directors.

The Act is clear when this test is required to be performed. The directors have to consider “all reasonably foreseeable financial circumstances of the company at that time”.

See also an excellent article by PwC on the solvency and financial liquidity of companies.

Solvency and liquidity fig 1Implicit is the need to consider all matters which may not necessarily be reflected in the books, accounting records and financial statements of the company.  This requires consideration of longer term risk and economic issues that may affect the enterprise.

The solvency and liquidity test is outlined in Section 4 of the Companies Act 2008.  It is worthy of being memorised by every director and Exco member.

In summarised format it provides that:

1.   the solvency and liquidity test is applicable for any purpose of the Act, and
2.   the company satisfies the test at a particular point in time if;

  • considering all reasonably forseeable financial circumstances at that time, including any reasonably forseeable contingent assets and liabilities;
  • the fairly valued assets exceed the fairly valued liabilities of the company,
  • based on accounting records and financial statements as defined in SS28 and 29, and
  • the company will be able to pay its debts as it becomes due in the ordinary course of business;

for a period of 12 months after the test is performed, or
for a period of 12 months after a “distribution” is made.

Due compliance with this section will undoubtedly result in significant additional administrative work. Executive management has to prepare management financial statements and updated forecasts covering the next 12 months.  This has to be done each time the board has to assess the company’s solvency and liquidity position going forward.