Contents
Introduction
Cash flow test and balance sheet test
The reasons of not having a single test
The definition and treatment of the debts and liabilities under the both tests
Bibliography
Introduction
The company’s inability to pay debts is the most common ground for the winding up of companies and, by definition, all-encompassing in the case of insolvent companies.
Under Maltese law section 214 (a) (ii) of Company Act 1995 states that the company may be dissolved and wound up by the court in case of the company is unable to pay its debts. The definition of this ground is to be found in sec. 214 (5) of Company Act. Based on it the inability to pay debts of the company can be proved by the way of two alternative tests: cash flow test and balance sheet test. These tests have different purposes. In simple words, cash flow test is in general about the debts which have already become due; balance sheet test is about the liabilities, e.g. contingent and prospective debts.
Before the consideration of these tests I would like to mention that even though Maltese Insolvency law is mainly based on UK Insolvency law, there are some differences between Maltese law and UK law in this question. The first difference is that under UK law the ground inability to pay debts can be applied in four scenarios, while in Maltese law there are only two of them. UK law describes the inability to pay debts in Insolvency Act 1986[1]. Also there is a difference between UK and Maltese cash flow test, it will be considered later on in this paper.
Cash flow test and balance sheet test
Cash flow test is more for the lawyers because you do not have to work with accounting documents of the company. All you need is the state of a fact that there is a debt unpaid for the period of 24 weeks after the issue of executive warrant on the basis of executive title.
The scheme of cash flow test can be represented as followed. There are two companies A and B. A owns B some money and does not pay it when it is due. B starts the case in a court against A and wins it, e.g. court issues a judgment in favour of B. A judgment is an executive title[2]. In perfect situation A must pay its debts to B on the basis of this judgment. But usually companies do not do it. Then a judgment creditor is appointed. The judgment creditor has a power to issue an executive warrant[3]. Usually it can be in three copies to the different banks where A has its accounts. The banks, in their turn, freeze the accounts of A and send the debt money on the accounts of B. If this scenario does not work, then B has to wait 24 weeks from the moment of issue the executive warrant and after can start the winding up proceedings against A.
Under UK law the cash flow test is different[4]. The company is deemed to be unable to pay its debts if a creditor to whom the company owes more then £750 immediately payable has delivered to it at its registered office a notice and the company has for three weeks thereafter neglected to pay the debt. Moreover, these twenty-one days should be clear. If the creditor presents the petition for winding up before the expiration of the time, he will not be able to rely on the company’s failure to comply with his demand for payment in the notice as proof of its inability to pay debts[5]. Above all, it must be shown that the company has neglected to pay the debt demanded. If the company, in good faith, disputes its liabilities, it can not be said to have neglected to pay the sum demanded[6].
Observing the authors, we find Sealy stating that cash flow test is the most common reason for making the winding up petition. Another author, Pennington, makes the definition of cash flow test very simple. Everything reduces to the presence of current cash. If a company does not have a cash to pay to a creditor, it is deemed to be insolvent.
Balance sheet test is more for the accountants. The balance sheet test for insolvency was first introduced in UK law in Insolvency Act 1985[7]. Balance sheet test will is to be satisfied if the company is unable to pay its debts on prospective and contingent liabilities. Maltese legislation endorsed balance sheet test. It is described under Maltese law in section 214 (5) (b) of Company Act 1995, and under UK law in section 123 (2) of Insolvency Act 1986.
Balance sheet test is a “red light” for the potential creditors. This solvency is very important for the creditors who are in a position to invest their money in a company. Usually, balance sheet test is more preferable than cash flow test because the creditors are more protected with it by giving them an opportunity to take into consideration future liabilities of the company and not only its present financial position. In other words, this test is much fair both to the company and the creditors. So, this test is all about the future possible liabilities, and the circumstances are varied depending on the particular case.