Insolvency in a nutshell
Insolvency, otherwise known as “business bankruptcy”, is when a business can no longer meet its financial obligations and is unable to pay its debts. A company which is insolvent is in danger of being closed down. This can have serious consequences for a business, including damage to its reputation and difficulty obtaining credit in the future.
Under the Insolvency Act 1986, there are three ways in which an insolvent company may be allowed to continue trading. The directors can:
- contact all the creditors to see if an informal agreement can be reached
- enter into a company voluntary arrangement (CVA)
- put the company into administration, which offers some respite from creditor action and enables the company to continue and its property to be sold.
Creditors can take action to recover debts by obtaining a court judgement or issuing a statutory demand (an official request for payment). However, if creditors are unable to recover their debts, they can request a winding-up order, which will force the company into compulsory liquidation. This is a formal process which is used for the sole purpose of closing a company and removing it from the Companies Register.
In some cases, a company may, by agreement with its shareholders, apply for a creditors’ voluntary liquidation (CVL). The advantage of this is that directors can take control of the process by choosing when to enter liquidation, and can appoint the liquidator of their choice. It also demonstrates they are aware of the company’s financial position, which reduces the risk of wrongful trading allegations. A recent study by Ernst & Young showed that CVLs accounted for 82% of all insolvencies in the first quarter of 2023 – a 12% increase from the same period in 2022.
The situation in the UK: turbulent times for companies
While there are early indications that insolvencies are now beginning to fall, they remain considerably higher than they were during the government support measures in response to the coronavirus (COVID-19) pandemic, and also higher than before the pandemic. Ernst & Young’s latest profit warnings report shows that UK-listed companies issued 75 profit warnings between January and March 2023, the highest first quarter total since the early stages of the pandemic in 2020. Since the start of 2022, 98 companies have issued at least two profit warnings. Of the 31 companies that have issued three warnings – and therefore considered to be in the ‘danger zone’ – since the start of 2022, 29% have since delisted or are in the process of being sold.
The technology and telecoms sectors have been hit particularly hard, accounting for one in five profit warnings in Q1 of 2023. This is mainly due to the fact that these sectors are especially vulnerable to cost-cutting and uncertain demand, with contract issues cited in over two-thirds (69%) of warnings. According to Creditsafe, the construction sector also shows significant insolvency numbers, representing 17% of all insolvencies in May 2023, with 449 construction companies becoming insolvent.
There are a variety of reasons for this alarming rise in insolvencies, including the increase in energy prices and the end of the government's Energy Bill Relief Scheme in March 2023. Consumer spending has decreased, with a corresponding rise in personal insolvencies (bankruptcies), which increased by 39% in March 2023 compared to the previous month. Increased borrowing costs and difficulties in obtaining financing have also been contributing factors, as has the end of COVID-19 support measures, with repayments on support debt now due.
What you can do: five tips and tricks to avoid insolvency
1. Manage your cash flow. Many cash flow problems can be averted by invoicing promptly, negotiating regular payments from long-term clients, addressing debts as soon as possible and ensuring unpaid bills do not pile up.
2. Know where your business is going. Have a formal business plan and update it regularly. Prepare monthly management accounts, and produce forecasts for at least a year ahead, updating these monthly.
3. Spread your risk. Don’t place undue reliance on any one customer or supplier. Have clear credit control procedures, and credit check all new customers. You might want to consider obtaining credit insurance against a customer’s failure to pay.
4. Build a strong relationship with your creditors. Maintaining good relations with creditors can reduce the risk of proceedings against you in the case of your business facing financial problems. Keep creditors informed at all times and build a good record of prompt payment.
5. Get professional advice. If your company is in financial difficulty, seek advice from a qualified solicitor, accountant, authorised insolvency practitioner or financial adviser. The Business Debtline provides free advice and resources on business finances and debts. The Insolvency Service also has information on debt relief options and how to undertake a company health check to minimise the risk of insolvency.