Understanding Cash Flow Insolvency

We understand how important it is for businesses to stay financially stable. One of the most common problems companies face is cash flow insolvency—a situation that can affect even profitable businesses. You might have strong sales or valuable assets, but without enough cash in the bank to cover bills, things can quickly get out of hand. In this guide, we explain what cash flow insolvency means, how it compares to balance sheet insolvency, the laws behind it, how to spot it early, and what you can do to prevent or manage it.

What Is Cash Flow Insolvency?

Cash flow insolvency happens when a business doesn’t have enough cash to pay its bills on time. Even if it owns buildings, equipment or stock, these can’t always be turned into cash quickly. So, while the company may appear valuable on paper, it struggles to pay staff, suppliers, or tax bills when they’re due.

This kind of problem is about liquidity—the cash a business has readily available—not how profitable or successful it looks from the outside. In fact, many businesses that face this issue have good long-term prospects but are let down by poor cash management or slow payments from customers.

Cash Flow and Balance Sheet Insolvency: What’s the Difference?

To fully understand the situation, it helps to compare cash flow and balance sheet insolvency. These are two different ways of looking at whether a company is financially healthy.

Cash flow insolvency focuses on whether the business can pay its bills right now or in the near future. It’s about short-term cash needs.

Balance sheet insolvency, also known as accounting insolvency, looks at the bigger picture. It happens when a company’s debts are greater than its assets. This means even if the company has enough money today, it’s not financially strong overall.

A company is insolvent when it fails either of these two tests. It might be unable to meet payments as they fall due (cash flow test) or owe more than it owns (balance sheet test). In serious cases, both issues are present at once.

Although economic insolvency is not a legal term, it often describes the overall state where a company cannot survive financially, whether because of cash flow, liabilities, or market pressures.

The Legal Framework: Insolvency Act 1986

In the UK, the Insolvency Act 1986 sets out the rules for what counts as insolvency. Section 123 of the Act explains two main tests:

• Cash flow test – if the company can’t pay its debts when they’re due
• Balance sheet test – if the company owes more than it owns, including future or potential liabilities

If a business fails either test, it is considered insolvent in the eyes of the law. This matters because it can lead to formal action, including liquidation, and directors have legal responsibilities to act once insolvency is clear.

If directors ignore these signs and carry on trading, they risk being accused of wrongful trading—where they knowingly run a company that can’t pay its debts. That can lead to personal consequences for the directors themselves.

The Cash Flow Test Explained

The cash flow test is about whether the company can meet its payment obligations when they’re due. This includes day-to-day bills like rent, wages, supplier invoices, and tax. To apply the test, businesses need to look at all money coming in—such as customer payments or loan funds—and compare it to what’s going out. If the business can’t cover those outgoings in time, it fails the test.

This test also takes into account payments due in the reasonably near future, although there’s no fixed timeline. The courts usually interpret this as a few weeks to a few months.

Even if a company expects to receive money later, if it doesn’t have enough to cover short-term debts, it could be classed as cash flow insolvent. While some delays might be acceptable, repeated problems are a warning sign.

Spotting the Warning Signs

Cash flow insolvency can sneak up on companies if they’re not paying close attention. Early warning signs often include:

• Late payments to suppliers or HMRC
• Difficulty paying wages or rent
• Frequent use of overdrafts or emergency loans
• A growing backlog of unpaid invoices
• Customers regularly paying late

These signs often point to poor cash management or delays in turning sales into income. If a business relies on a small number of large clients or offers long payment terms, this can create risky gaps in cash flow.

It’s also important to look at trends over time. A single missed payment isn’t necessarily insolvency, but repeated problems or a constant struggle to stay afloat suggest deeper issues.

Why Cash Flow Insolvency Matters

Failing the cash flow test can have serious effects. Once a company is insolvent, it must change the way it operates. Directors have a duty to protect creditors—not shareholders—and may face legal consequences if they carry on trading as normal.

If the business can’t pay its debts and doesn’t act, creditors may start legal action, and the court could order the company to be wound up. This leads to formal insolvency procedures, such as:

• Company administration – where an administrator is appointed to manage the company and protect it from creditors
• Company Voluntary Arrangement (CVA) – an agreement with creditors to pay part of what’s owed over time
• Creditors’ Voluntary Liquidation (CVL) – a formal closure of the company where assets are sold to repay debts

All of these options involve the company losing control over its finances to some degree, so early action is crucial.

How to Deal with Cash Flow Insolvency

Fortunately, if you spot the issue early, there are ways to fix it. The first step is to create a detailed cash flow forecast. This will help you see when you’re likely to run into trouble and allow you to plan around it.

You can also look at speeding up how you get paid. This might mean:

• Sending invoices as soon as work is complete
• Following up with customers who are slow to pay
• Offering discounts for early payment

If you’re struggling to pay suppliers, talk to them. Many will be willing to extend terms for trusted partners, especially if you’re open about your position. Another option is to look at short-term finance. This could include:

• Invoice finance – where you borrow against unpaid invoices
• Overdrafts or business credit lines – to manage shortfalls
• Asset-based lending – borrowing against vehicles or equipment

At the same time, cutting costs where possible can ease pressure. Review any spending that isn’t essential, delay big purchases, and pause non-critical projects until things stabilise.

How to Avoid Insolvency in the First Place

At Campbell Crossly & Davis, we help businesses put the right systems in place to prevent cash flow insolvency. The key is to monitor finances closely and plan ahead.

Start by regularly updating a cash flow forecast. This gives you early warning of potential problems and allows you to act before things go wrong. Use good accounting software to track payments, and make sure your team follows up on overdue invoices.

Avoid relying too heavily on one or two customers, and make sure your contracts set clear payment terms. Building a buffer of cash or having access to flexible funding also gives you room to deal with sudden changes.

Finally, don’t ignore problems. If payments are slowing down or costs are rising, look at your figures in detail and consider seeking professional advice.

Your Responsibilities as a Director

Once your company is facing financial trouble, your legal duties change. From that point, you must put creditors’ interests first. Failing to do so—such as taking on new debt you know you can’t repay—can lead to personal liability.

That’s why seeking advice early is so important. Working with a licensed insolvency practitioner can protect you from legal risk and help you find the best way forward. They can help assess your position, explain your options, and, if needed, support you through formal processes like administration or liquidation.

Take Action Before It’s Too Late

Cash flow and balance sheet insolvency are challenges that many businesses face, but they don’t have to lead to closure. The key is to act early, stay informed, and use the right tools and advice.

If you think your business might be heading towards economic insolvency, now is the time to speak with professionals who can help. At Campbell Crossly & Davis, we specialise in guiding companies through financial difficulty. Whether you need help improving cash flow, understanding your legal position, or finding a rescue solution, we’re here to support you. Get in touch with us today for a confidential, no-obligation consultation. Together, we can explore your options and help your business find a path to financial stability.