Insolvent trading is a common and costly failure of directors when a business gets into financial trouble. A lack of knowledge surrounding director duties often leaves directors pulling the pin too late, leaving themselves personally liable.
This article explains, in simple terms, what insolvent trading is, how to recognise the warning signs, and what directors should (and should not) do if insolvency is a possibility.
What is Insolvent Trading?
Insolvent trading is when a company incurs debts without sufficient means of paying them. To classify, a director must have known, or ought reasonably have known, that insolvency was occurring when the debts were incurred.
Once a company is unable to pay its debts, continuing to trade means a company is incurring new debts and exposing new creditors to liabilities they will likely not recover. The law therefore requires directors to stop the company from incurring further debts once insolvency is suspected (not confirmed).
Liabilities of directors (if insolvent trading is established)
- Personal liability for company debts incurred during the period of insolvent trading;
- Compensation claims brought by a liquidator;
- Civil penalties imposed by the court; and
- In serious cases, disqualification from managing corporations or criminal consequences.
How Do I Know When My Company Is Insolvent?
Insolvency is not solely determined by whether a business is profitable on paper or whether it owns valuable assets. The key question is whether the company can pay its debts as and when they fall due. Common red flags include:
- Regularly paying creditors late, including statutory liabilities such as ATO or payroll tax;
- Entering payment plans to meet basic expenses;
- Continued trading losses; and
- Relying on director loans to meet everyday expenses or payroll.
A company doesn’t need to have missed every bill to be insolvent. Persistent cash stress is often enough. However, short-term cash flow constraints do not always indicate insolvency. Temporary timing issues or one-off disruptions may affect otherwise solvent businesses. ASIC provides a helpful list of signs to look for here.
Working Capital
A company’s working capital position is its ability to meet short-term obligations using current assets.
When current liabilities consistently exceed current assets, the company may lack sufficient liquidity to pay debts as they fall due. Negative or deteriorating working capital can be an early warning sign.
Regular reliance on extended creditor terms, short-term borrowing, or delaying payments to manage day-to-day expenses indicates that a business is effectively funding operations through its creditors.
Note: A company’s financials are only valuable if they are accurate. Consider seeking professional guidance when preparing and evaluating your company’s financials.
What Do I Do If I Think My Company Is Insolvent?
The worst thing a director can do is ignore the problem. If insolvency is suspected, directors should:
- Stop and assess – Pause from incurring new debts where possible.
- Get professional advice early – Speak with an insolvency practitioner or a qualified professional.
- Consider restructuring or formal options – Such as a small business restructure, voluntary administration, or liquidation.
What Not to Do (Common Pitfalls)
- “Trading out” without a plan – Hope is not a strategy. Continuing to trade without a realistic, documented plan is one of the fastest ways into insolvent trading claims.
- Seeking predatory loans – Seeking short-term, high-interest loans to meet creditor payments is a dangerous band-aid for a greater issue.
- Ignoring statutory debts – Unpaid tax and superannuation are compounding liabilities that can become unmanageable if not tended to. The ATO has the power to issue Director Penalty Notices, which have the ability to hold directors personally liable for company debts.
Key Takeaways
Insolvent trading is rarely the result of a single bad decision. More often, it is caused by delay, denial, and a lack of understanding of directors’ legal obligations.
Directors do not need to predict the future perfectly—but they do need to stay informed, act prudently, and respond decisively when financial distress arises.
If you suspect that your company may be insolvent, now is the time to engage experienced advisors. DVT Mcleods can assist directors in understanding their position and evaluating their options going forward.
Contact DVT Mcleods at mail@dvtmcleods.au or via phone on 02 9633 3333 for a no-obligation discussion today.
Disclaimer: all advice is general and should not be considered as insolvency or legal advice.
