In brief: The cash flow test asks whether your company can pay its debts when they fall due. The balance sheet test compares what its assets are worth with what it owes, including obligations that may arise later. If either test raises concerns, gather your latest figures and speak promptly to a licensed insolvency practitioner.
A business can report a profit and still be unable to meet Friday’s payroll. It can also pay this week’s bills while carrying obligations that its assets cannot support. Those are two different problems. The cash flow and balance sheet tests help directors ask the right questions about each one.
This guide explains the tests in practical terms for directors in England and Wales. The figures below are invented and deliberately simple. If your own company shows signs of insolvency, speak to a licensed insolvency practitioner promptly. Ask a solicitor for legal advice where the conclusion depends on a disputed debt, contract or guarantee.
The cash flow test asks whether the company can pay on time
Set out what is due and when, then compare it with cash and funding the company can actually use. Start with the bank balance available for trading. Add expected customer receipts on realistic dates. Deduct payroll, tax, rent, finance payments and supplier bills on the dates they fall due. Separate signed funding commitments from applications or verbal assurances.
The Insolvency Service’s explanation of company insolvency describes inability to pay debts on time as one way a company can be insolvent. A forecast helps you see the issue, although a legal assessment involves the facts of the company’s position. A shortfall that appears on paper should prompt a discussion about the obligations falling due and what funds are genuinely available to meet them.
Worked example: a profitable order that pays too late
Suppose a business has £18,000 available on Monday. Payroll and essential supplier invoices totalling £29,000 fall due on Friday. A customer owes £22,000 but has confirmed that it will pay in three weeks. Assume there are no other receipts or facilities available by Friday. The company is £11,000 short at the point those obligations fall due.
Three weeks later the balance may look healthier. That does not give the company money for Friday. Ask what can be established now. Does the company have a facility it can actually draw? Has anyone confirmed a different payment date in writing? Could the customer pay part of the invoice early? If none of that is available, show the forecast as it stands. Do not move a date simply to make the column balance.
See the cash flow forecasting guide for SMEs for help building a rolling view. If a missed VAT or payroll tax payment is part of the problem, the guide to HMRC arrears and Time to Pay explains how to prepare for a conversation with HMRC. Check the wider company position at the same time.
The balance sheet test looks at what the company owns and owes
The other test compares the value of the company’s assets with its liabilities. The legislation includes contingent and prospective liabilities. In plain English, some obligations may arise in the future or depend on an event. The value and timing of those obligations may need specialist assessment. See section 123 of the Insolvency Act 1986 for the legal wording.
Start with management accounts and the latest balance sheet. Then ask what the numbers represent. How much of the stock can the company realistically sell? Which invoices are disputed or unlikely to be collected? What are the assets actually worth in the circumstances? Identify which equipment is owned by the company and which is leased. Add known commitments and flag anything uncertain for the accountant and practitioner.
Worked example: a positive book balance that needs testing
Suppose a company’s accounts show assets of £150,000 against liabilities of £130,000. It appears to have a £20,000 margin. The asset figure includes stock carried at £50,000. For this illustration, assume a credible valuation puts that stock at £25,000. Assume also that there is a further £10,000 company obligation which should be included at that value, and leave every other number unchanged.
The adjusted assets would be £125,000 and liabilities £140,000, a gap of £15,000. The business could still have cash available for its next payroll. The example shows why a healthy bank balance and a positive historic balance sheet cannot settle the question. Real valuations and the treatment of uncertain obligations depend on the circumstances. Ask the practitioner to review the assumptions rather than treating the calculation as a legal conclusion.
Put both views side by side
Use the same date for the starting balances and reconcile the forecast with the most recent bank and accounting records. The cash forecast should show when obligations have to be met. The balance sheet work should show what assets and liabilities may be worth. If the conclusions point in different directions, note why. That discrepancy is information your adviser can use.
A few notes against the largest figures are often more valuable than another spreadsheet tab. Mark the receipt that depends on a customer signing off work. Identify the finance facility that may require the lender’s consent. If an estimate depends on a valuation, write down who supplied it and when. Make it easy for someone else to see what would change the result.
Use the warning signs that a business may need restructuring to look at what sits behind the numbers. Repeated late payments, management time spent moving bills around and increasing personal support point to questions a single month’s figures can miss.
What to do if either test raises concern
Bring the directors together promptly. Agree what the figures show, what still needs checking and which decision cannot wait. Contact a licensed insolvency practitioner and share the forecast, accounts, creditor schedule and finance agreements. Mention any demand, petition or court date at the start of the conversation. Speak to a solicitor about legal documents or disputed obligations.
While advice is being sought, identify decisions that could add to creditor losses or benefit a director personally. Examples include accepting new deposits when delivery is uncertain, repaying money you lent the company or taking on stock you may be unable to pay for. Discuss those decisions with the practitioner before proceeding. The article on director duties when the company is struggling covers what to record and why creditor interests matter.
Put a date on the next review and update the figures sooner if a major receipt slips or a creditor changes its position. Keep the earlier forecast as well. The board should be able to see what it knew at each point and how the position changed. Ask the adviser what developments would mean you need to speak again immediately.
The useful question to ask first
Start with the next debt the company may be unable to pay. Identify the date, what is genuinely available and what action depends on someone else agreeing. Then look at whether the company’s assets can support its obligations beyond that date. The aim is to bring two clear, evidence-based views to the people who can advise on the next decision.
The director’s guide to the financial pressure series links these tests to tax arrears, creditor action and the formal options a practitioner may discuss.
If you would like help organising the figures and deciding what needs attention first, G&G offers a free 30-minute consultation. For legal or insolvency advice, speak to a solicitor or a licensed insolvency practitioner.
