What are balance sheet tests?
A rather wide question. In the context of insolvency, a balance sheet is deemed to be insolvent if it shows negative shareholders’ funds. This situation usually arises out of continued loss making activity. However, a company can have positive shareholders’ funds and still be technically insolvent. This latter situation usually arises where a company has significant fixed assets supporting its balance sheet, i.e. freehold property, plant and machinery etc, although its current assets, i.e. the assets that it uses to trade with on a daily basis being stocks, debtors etc, are less than its current liabilities, i.e. the amounts it owes to its suppliers.
What is balance sheet insolvency?
The definition of insolvency is “the inability to discharge your liabilities as and when they fall due”.
To demonstrate this, we have set out below an example of a balance sheet, that, whilst showing the company to have positive shareholders’ funds, on a technical basis, is actually insolvent.
| Fixed assets | £000 | £000 |
| Freehold property | | 860 |
| Plant & machinery | | 390 |
| Current Assets | | |
| Stock & WIP | 540 | |
| Debtors | 430 | |
| Total current assets | 970 | |
| Creditors less 1 year | (1530) | |
| Net current liabilities | | (560) |
| Net assets | | 690 |
| Share Capital | | 1 |
| Profit & loss account | | 689 |
| Shareholder’s funds | | 690 |
What are cash flow tests?
This is slightly easier to explain and to some degree follows the premise described above. Cash flows are perhaps more important than the traditional profit and loss statement, given that without the ability to pay suppliers, most company’s life’s will be fairly short. Cash flow is the absolute heart of any business. There is little point in making paper profits, if your customers/clients are not paying on time and causing you problems with paying your suppliers. A sale with a decent margin is only of real value to you once you have been paid. Debtors on the balance sheet do not pay the bills – as is evidenced by the balance sheet above.
Control over cash flow is absolutely critical if you are to manage your company’s finances effectively. It is fairly important therefore to run and regularly update a cash flow model. This doesn’t have to be complicated – all you really need is to input forecast sales with the timing of forecast receipts and against that enter known payments due.
A simple cash flow forecast will highlight when you may have a problem in paying suppliers on time. None of us like to consider bad news, but you are much better off being made aware of a potential problem at as early a stage as possible, in order that you may then have more time to try and find a solution to the problem.
UK Wide Support for Businesses from our Offices in London & Nottingham
If you are experiencing cash flow problems, contact us today. We will provide free advice and a no obligation consultation. Call or fill in our enquiry form and one of our licensed insolvency practitioners will get in touch with you within 24 hours.
We have offices in London, Nottingham and Derby, so we are well placed to support businesses UK wide. We are happy to travel to meet you at a convenient location.
Contact details for London Businesses: Insolvency Advice and Services
Contact details for Nottingham Businesses: Insolvency Advice and Services
Contact details for Derby Businesses: Insolvency Advice and Services
FAQs
Both cash flow and balance sheet insolvency tests are important to assess a company's financial health. There are a couple of key differences between the pair: Balance sheet insolvency compares assets and liabilities. Cash flow insolvency compares available cash flow to meet outgoings on time.
What is the balance sheet and cash flow test? ›
The cash-flow test considers the ability of a company to pay its debts (or liquidate assets fast enough to satisfy its debts) as they become due and payable. The balance-sheet test assesses the solvency of a company by assessing its total external liabilities against the total value of its assets.
What is a balance sheet test? ›
The balance sheet test considers a companies assets (the things it owns) and weighs these alongside its liabilities (its debts). If its liabilities are greater than its assets then the company can be said to be balance sheet insolvent.
What is cash flow and balance sheet? ›
A balance sheet shows what a company owns in the form of assets and what it owes in the form of liabilities. A balance sheet also shows the amount of money invested by shareholders listed under shareholders' equity. The cash flow statement shows the cash inflows and outflows for a company during a period.
What are 2 cash flow questions that balance sheets can answer? ›
The balance sheet can help users answer questions such as whether the company has a positive net worth, whether it has enough cash and short-term assets to cover its obligations, and whether the company is highly indebted relative to its peers.
What is cash flow testing? ›
Home » Cash Flow Testing. A form of cash flow analysis involving the projection and comparison of the timing and amount of cash flows resulting from economic and other assumptions.
What comes first cash flow or balance sheet? ›
The three core financial statements are 1) the income statement, 2) the balance sheet, and 3) the cash flow statement. These three financial statements are intricately linked to one another.
What is the balance sheet in simple terms? ›
A balance sheet is a financial statement that contains details of a company's assets or liabilities at a specific point in time. It is one of the three core financial statements (income statement and cash flow statement being the other two) used for evaluating the performance of a business.
What is included in testing for the balance sheet? ›
The strength of a company's balance sheet can be evaluated by three broad categories of investment-quality measurements: working capital, or short-term liquidity, asset performance, and capitalization structure. Capitalization structure is the amount of debt versus equity that a company has on its balance sheet.
What will a balance sheet tell you? ›
Introduction. The balance sheet provides information on a company's resources (assets) and its sources of capital (equity and liabilities/debt). This information helps an analyst assess a company's ability to pay for its near-term operating needs, meet future debt obligations, and make distributions to owners.
A cash flow statement tracks the inflow and outflow of cash, providing insights into a company's financial health and operational efficiency. The CFS measures how well a company manages its cash position, meaning how well the company generates cash to pay its debt obligations and fund its operating expenses.
Why cash flow is more important than balance sheet? ›
As a reminder, the balance sheet provides a snapshot of the company's liabilities and assets at a given time. On the other hand, the cash flow statement shows the activities that occurred during the period that contributed to any changes in account balances.
What is the definition of cash flow? ›
Cash flow is the movement of money in and out of a company. Cash received signifies inflows, and cash spent is outflows. The cash flow statement is a financial statement that reports a company's sources and use of cash over time.
What is the difference between a balance sheet and a cash flow test? ›
Both cash flow and balance sheet insolvency tests are important to assess a company's financial health. There are a couple of key differences between the pair: Balance sheet insolvency compares assets and liabilities. Cash flow insolvency compares available cash flow to meet outgoings on time.
How to check cash flow is correct? ›
How can you ensure cash flow statement accuracy?
- Review your income statement and balance sheet.
- Categorize your cash flows correctly. ...
- Use the indirect method for operating cash flows. ...
- Reconcile your cash flows with your bank statements. ...
- Use accounting software and tools. ...
- Here's what else to consider.
Assets = Liabilities + Owner's Equity. This is the basic equation that determines whether your balance sheet is actually ”balanced” after you record all of your assets, liabilities and equity. If the sum of the figures on both sides of the equal sign are the same, your sheet is balanced.
Should balance sheet and cash flow statement match? ›
If your ending cash balance on your statement of cash flows doesn't match the cash balance on your balance sheet, you've made a mistake somewhere and will need to investigate the difference.
What is the balance sheet forecast and cash flow? ›
A balance sheet forecast is an estimation of your company's assets, liabilities, and equity in the near future. A balance sheet forecast is part of a three statement financial model (along with your income statement forecast and cash flow forecast) that projects material changes in your company's cash balance.
How do you reconcile a balance sheet and cash flow statement? ›
Reconciling cash balances on a cash flow statement involves adding the net cash flow from operating, investing, and financing activities to the beginning cash balance. This should equal the ending cash balance reported on the balance sheet.
What is the difference between P&L balance sheet and cash flow statement? ›
The main difference between a profit and loss statement and a cash flow statement is that a profit and loss statement measures the profitability of the business model while a cash flow statement shows where your money is coming from, where it's going, and how much cash you actually have on hand at a given point in time ...
