What it means
The test is arithmetic rather than dramatic: add up everything the business owns, add up everything it owes, and if the second number is larger, the company is accounting insolvent. Directors, lenders and auditors watch this figure because it signals that the company could not repay everyone if it stopped trading today.
The point that surprises people is that accounting insolvency is not the same as failure. A young company that has raised debt to fund development, or a business that has taken a large one-off write-down, can show negative net assets and still trade profitably and pay its suppliers without difficulty.
The reverse also happens and is usually more dangerous in the short term. A property business with $8,000,000 of buildings and $2,000,000 of debt is comfortably solvent on paper, but if the buildings cannot be sold quickly it may still fail to meet a payment falling due next week.
Measurement choices affect the answer considerably. Assets carried at historical cost can be worth far more than the balance sheet says, while internally generated brands and customer relationships appear nowhere at all, so a company can look accounting insolvent while a buyer would happily pay a substantial sum for it.
For directors the practical consequence is a duty of care. Once a company is or is close to being insolvent on either test, the interests of creditors start to take priority over shareholders, and continuing to trade up debts without a realistic recovery plan can carry personal consequences.
In practice
Real-world examples.
Example
A biotechnology company has spent $30,000,000 of investor money on research that is expensed as incurred, leaving accumulated losses larger than its remaining assets. It is accounting insolvent on paper, but with $14,000,000 of cash in the bank and no near term repayments, it pays every supplier on the day the invoice falls due.
Example
A retailer takes a $6,000,000 impairment on store fittings after closing a third of its estate, tipping net assets to negative $1,200,000. The bank waives a covenant breach in exchange for a repayment schedule and monthly management accounts, because the underlying trading is recovering.
Example
A family engineering firm looks accounting insolvent because its factory sits in the books at a 1990s cost of $400,000 against $900,000 of debt. An independent valuation puts the site at $2,300,000, and once the property is revalued the balance sheet shows positive net assets of about $1,000,000.
Formula
Calculation
Net assets = total assets - total liabilities
Accounting insolvency exists when net assets are negative.
A regional haulage company has the following position at its year end. Assets: vehicles and equipment $1,450,000, trade receivables $520,000, inventory of parts and fuel $130,000, and cash $200,000.
Total assets = $1,450,000 + $520,000 + $130,000 + $200,000 = $2,300,000.
Liabilities: bank and asset finance debt $1,900,000, trade payables $610,000, and accrued expenses $240,000.
Total liabilities = $1,900,000 + $610,000 + $240,000 = $2,750,000.
Net assets = $2,300,000 - $2,750,000 = -$450,000.
The company is accounting insolvent by $450,000. Yet if it generates $60,000 a month of operating cash against $45,000 a month of debt service and can keep doing so, it remains able to pay its debts as they fall due, so it is not cash flow insolvent. The two tests answer genuinely different questions, and a lender will look at both.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Pentland Coachworks, an invented vehicle conversion business, ended a difficult year with total assets of $2,300,000 and total liabilities of $2,750,000, so its net assets stood at -$450,000. The auditors raised the question of whether the company remained a going concern.
Cash told a very different story. The order book was full, monthly operating cash inflow was running at about $60,000 against $45,000 of loan and lease payments, and no significant repayment fell due for two years. The deficit came almost entirely from a $700,000 write-down of a discontinued product line, not from trading.
The directors of the fictional company put together a two year plan showing the deficit closing through retained profit at roughly $180,000 a year, and the majority shareholder subordinated a $500,000 loan so it ranked behind other creditors. That combination satisfied the auditors, and the accounts were signed with a going concern note rather than a qualification.
Watch out
Common mistakes.
- Treating accounting insolvency as automatic proof that a company is about to fail, when many solvent, well funded businesses show negative net assets for a period.
- Checking only the balance sheet test and ignoring cash flow insolvency, which is usually the one that actually stops a business trading.
- Relying on historical cost figures for property and equipment, which can understate asset values badly and make a healthy business look insolvent.
Questions
People also ask.
What is the difference between accounting insolvency and cash flow insolvency?
Accounting insolvency compares total assets with total liabilities, while cash flow insolvency asks whether the business can pay its debts as they fall due.
Can a company trade while accounting insolvent?
Often yes, provided the directors have reasonable grounds to believe it can meet its obligations, though they should take advice and document the basis for continuing.
How can negative net assets be corrected?
Usually by retaining future profits, converting debt into equity, injecting new capital, or revaluing assets that are genuinely worth more than their carrying value.
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