The short answer
A company is insolvent when it cannot pay its debts. UK law uses two tests under section 123 of the Insolvency Act 1986: the cash-flow test (it cannot pay debts as they fall due) and the balance-sheet test (its liabilities exceed its assets). Failing either can make a company insolvent. Being insolvent is not the same as being insolvent and closing — but it does change a director’s legal duties.
“Insolvent” is a word directors fear, yet it has a precise legal meaning rather than a vague sense of trouble. This guide explains the two statutory tests, why the distinction matters, and how to tell genuine insolvency apart from an ordinary cash squeeze.
Insolvency at a glance
- Legal source s.123 Insolvency Act 1986
- Cash-flow test Cannot pay debts as they fall due
- Balance-sheet test Liabilities exceed assets
- Either test Can establish insolvency
- Key effect Director duties shift to creditors
- Not the same as Closing or being wound up
The two legal tests of insolvency
Under section 123 of the Insolvency Act 1986, a company is deemed unable to pay its debts — that is, insolvent — if it fails either of two tests. The two tests look at the company from different angles: one at its day-to-day ability to meet bills, the other at the overall shape of its balance sheet. A company can be insolvent on one test while appearing healthy on the other, which is precisely why both matter. Directors should keep both in mind, because the law does not require both to be failed — failing just one is enough to make the company insolvent in the eyes of the law.
| Test | Question it asks | Typical evidence |
|---|---|---|
| Cash-flow test | Can the company pay its debts as they fall due? | Missed payments, unpaid HMRC, overdue suppliers |
| Balance-sheet test | Do liabilities (including contingent and prospective) exceed assets? | Net liabilities on a realistic valuation |
The cash-flow test
This is the most common trigger in practice. If a company cannot meet its bills when they are due — wages, rent, supplier invoices, a VAT or PAYE bill — it is failing the cash-flow test, even if its accounts still show assets on paper. The focus is on debts that are presently due, and increasingly the courts also consider debts falling due in the reasonably near future. A single late payment is not proof of insolvency; businesses pay late for all sorts of innocent reasons. What matters is a settled, ongoing inability to pay on time. Signs that the cash-flow test is being failed include county court judgments, final demands, a reliance on stretching every supplier, and an inability to meet payroll or tax without robbing one creditor to pay another.
The balance-sheet test
Here the question is whether the company’s liabilities, taking into account its contingent and prospective debts, exceed its assets. A company can comfortably pass the cash-flow test today — it has cash in the bank — yet still be balance-sheet insolvent because of large future, disputed or contingent liabilities such as a looming legal claim, a dilapidations bill or a guarantee that may be called. The courts apply this test commercially and with common sense, not as a rigid arithmetic snapshot: they ask whether, looking at the whole picture, the company has reached a point of no return. Asset values must be realistic — what they would actually fetch — not optimistic book figures.
Insolvency versus simply struggling
It is important not to confuse genuine insolvency with the ordinary turbulence of running a business. Many healthy companies have tight months, slow-paying customers and seasonal dips that they trade through without difficulty. The distinction matters because it changes a director’s legal duties.
- Struggling — a tight month, a slow debtor, a seasonal dip you can clearly trade through.
- Insolvent — a settled inability to pay debts as they fall due, or net liabilities on a realistic view.
- The danger zone — trading on while insolvent, hoping it improves, when there is no reasonable prospect of recovery.
What insolvency does not mean
Being insolvent does not automatically mean liquidation, court action or the end of the business. It is a financial state, not a sentence. Many insolvent companies are successfully rescued through administration or a company voluntary arrangement, while others are wound down in an orderly, lawful way that protects creditors. What insolvency does mean is that the rules change: directors must start acting in the interests of creditors rather than shareholders, must avoid worsening the position, and must recognise that only a licensed insolvency practitioner can carry out a formal procedure. Taking advice early, while options are still open, almost always produces a better outcome than waiting.
Not sure whether your company is genuinely insolvent?
A licensed insolvency practitioner can apply both tests to your real numbers and tell you where you stand. A short, confidential call costs nothing.
Frequently asked questions
Can a company be insolvent but still have cash in the bank?
Yes. It can pass the cash-flow test yet fail the balance-sheet test if its liabilities — including contingent or future debts — exceed its assets on a realistic valuation.
Is being insolvent illegal?
No. Insolvency itself is not an offence. What can create liability is continuing to trade and worsen creditors’ position when there is no reasonable prospect of avoiding insolvent liquidation.
Who decides if a company is insolvent?
Directors should assess it using the s.123 tests, ideally with professional advice. A court ultimately decides if the question reaches a winding-up petition.
Does insolvency mean the company must close?
Not necessarily. Insolvent companies can be rescued through administration or a CVA, or wound down in an orderly way. Insolvency changes the rules, not the outcome.
Sources & further reading
- Insolvency Act 1986 — s.123 (definition of inability to pay debts)
- GOV.UK — Options for a company in financial difficulty
- The Insolvency Service — guidance for company directors
- GOV.UK — Liquidation and insolvency overview
This guide is general information, not formal insolvency advice. Your situation must be assessed by a licensed insolvency practitioner before you act.