A company’s solvency can come into play if it paid another creditor when it had an obligation to pay you first. If such circumstances lead to litigation, you should consider hiring a solvency expert to determine whether the company actually could meet its long-term interest and repayment obligations at the time of the payment.
Three tests
Solvency experts consider several key issues when examining a subject:
- Does it have positive equity — that is, does its assets exceed liabilities?
- Is it able to pay off debts as they come due?
- Does it possess adequate capital to operate?
With those questions in mind, the expert applies three tests to analyze solvency:
- Balance sheet. At the time of the transaction at issue, did the subject’s asset value exceed its liability value? Assets are generally valued at fair market value, rather than at book value. The latter is typically based on historic cost, and fixed assets (such as vehicles and equipment) may be reduced by annual depreciation expense. But the balance sheet is just a starting point. Adjustments may be needed to balance sheet items so they more accurately reflect the fair market value of assets.
- Cash flow. This test examines whether the subject incurred debts that were beyond its ability to pay as they matured. It involves analysis of a series of projections of future financial performance. Experts consider a range of scenarios. These include management’s growth expectations, lower-than-expected growth, and no growth as well as past performance, current economic conditions, and future prospects.
- Adequate capital. The final test determines whether a company is likely to survive in the normal course of business, bearing in mind reasonable fluctuations in the future. In addition to looking at the value of net equity and cash flow, experts consider factors such as asset volatility, debt repayment schedules, and available credit.
All or nothing
A company must pass all three of these tests to be considered solvent. Courts generally presume a company is insolvent, unless it is proven otherwise. With a comprehensive solvency analysis performed by a credentialed valuation expert, you can provide objective support for your position. Contact us for more information.