Corporate and Business Law (Global) · Insolvency and administration

Corporate Insolvency Basics and the Insolvency Tests

Updated 11 October 2026 · Fact-checked

A company is insolvent when it cannot pay its debts. Two tests are used: the cash flow test (it cannot pay debts as they fall due) and the balance sheet test (its liabilities exceed its assets). Insolvency is a financial state. Liquidation and administration are procedures that may follow.

Understand Corporate Insolvency Basics and Insolvency Tests

Insolvency is a financial condition. A company is insolvent when it cannot meet its debts. It is not a legal procedure. A company can be insolvent and still trade for a while, and a company can be wound up even when it is solvent.

There are two main tests. The cash flow test asks whether the company can pay its debts as they fall due. A company may own valuable assets but have no cash to pay a bill that is due now. It fails this test. The balance sheet test asks whether the company's total liabilities are greater than its total assets. Here you compare what it owns with what it owes, often including contingent and prospective liabilities.

A third idea you may meet is that a creditor can show insolvency by serving a formal written demand for a debt that stays unpaid for a set period, or by showing that a court judgment remains unsatisfied. The exact rules differ by country, so in the Global exam focus on the general principles and the wording of the question.

Insolvency then leads to procedures. Liquidation (winding up) ends the company: an appointed liquidator collects the assets, sells them, pays creditors in the legal order and the company is then dissolved. Administration is different. An administrator takes control to rescue the company, achieve a better result for creditors than liquidation, or sell assets for creditors. Other options include a company voluntary arrangement (an agreement with creditors) and receivership (a secured creditor's appointee takes assets to repay that creditor).

Keep the link clear: insolvency is the problem, the procedures are the responses. The main aim of most insolvency law is to protect creditors and ensure fair treatment of them.

Key formulas to remember

Cash flow test: Insolvent if: debts falling due cannot be paid when due; Looks at liquidity now and in the near term. Assets do not matter if they cannot be turned into cash in time.
Balance sheet test: Insolvent if: total liabilities > total assets; Looks at net position. Include contingent and prospective liabilities where the question says so.
Insolvency vs liquidation: Insolvency = state; liquidation = procedure; Insolvency may lead to liquidation, but is not the same thing.

How to solve Corporate Insolvency Basics and Insolvency Tests questions

Use this method for any question on insolvency basics, whether it is a short objective question or a scenario task.

1Read the question and decide what is being asked: a definition, a test, or a procedure.
2If a test is needed, identify the facts: debts due now, cash available, total assets and total liabilities.
3Apply the cash flow test first: can the company pay debts as they fall due? State yes or no.
4Apply the balance sheet test: compare total liabilities with total assets. State the result.
5Say that failing either test shows the company is insolvent. Passing one does not prove solvency.
6Identify the suitable procedure: liquidation to end the company, administration to rescue or preserve value, a CVA to agree terms with creditors.
7Write a clear conclusion tied to the facts in the scenario.

Quickest way: Two-test shortcut

When to use it: For one- and two-mark objective questions where you have about a minute.

Ask: can it pay bills now? If no, cash flow test failed.
Ask: do liabilities exceed assets? If yes, balance sheet test failed.
If either fails, choose insolvent.
If the question asks about ending the company, think liquidation. If it asks about rescue, think administration.

Common mistakes in Corporate Insolvency Basics and Insolvency Tests

Treating insolvency and liquidation as the same thing.
The words are used together in news and everyday speech.
Fix: Remember: insolvency is a financial state; liquidation is a legal procedure that ends the company.
Saying a company is solvent because assets exceed liabilities.
Students apply only the balance sheet test.
Fix: Always check the cash flow test too. A company with illiquid assets can still be insolvent.
Saying a company must be insolvent to be liquidated.
Students assume all liquidations follow failure.
Fix: A solvent company can be wound up by its members. Insolvency is not required for every winding up.
Confusing administration with liquidation.
Both involve an appointed insolvency practitioner.
Fix: Administration aims to rescue or get a better result for creditors. Liquidation realises assets and ends the company.
Ignoring contingent or future liabilities in the balance sheet test.
Students count only current debts.
Fix: When the question mentions contingent or prospective liabilities, include them in the comparison.

Worked examples

Example 1

X Ltd has assets of $900,000 and liabilities of $700,000. It owes a supplier $150,000 due today but has only $20,000 in cash and cannot sell its assets quickly. Is X Ltd insolvent?

Show the solution

Balance sheet test: assets $900,000 exceed liabilities $700,000. Net assets are $200,000. The test is passed.
Cash flow test: a debt of $150,000 is due today and only $20,000 cash is available. The company cannot pay debts as they fall due. The test is failed.
Failing either test shows insolvency.

Answer: X Ltd is insolvent under the cash flow test, even though it passes the balance sheet test.

Example 2

Explain the difference between insolvency and liquidation, and name one procedure aimed at rescuing an insolvent company.

Show the solution

Define insolvency: a state where a company cannot pay its debts, shown by the cash flow or balance sheet test.
Define liquidation: a procedure in which a liquidator collects and sells assets, pays creditors in the legal order and the company is then dissolved.
Show the link: insolvency may lead to liquidation, but a company can be insolvent without being in liquidation, and a solvent company can be wound up.
Name a rescue procedure: administration, where an administrator tries to rescue the company or get a better result for creditors than liquidation.

Answer: Insolvency is the financial condition of being unable to pay debts; liquidation is a procedure that ends the company. Administration is a rescue-focused procedure.

Exam tips

In scenario questions, test both cash flow and balance sheet separately and show each result.
Read figures carefully: a long-term debt not yet due does not fail the cash flow test today.
Use the exact words: insolvency is a state, liquidation and administration are procedures.
For procedure questions, match the aim to the facts: rescue points to administration or a CVA; ending the business points to liquidation.
Objective questions are all or nothing, so check every option for equivalent traps before choosing.

Practice questions from Insolvency and administration

Corporate Insolvency Basics and Insolvency Tests in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Corporate Insolvency Basics and Insolvency Tests: frequently asked questions

What is the difference between the cash flow test and the balance sheet test?

The cash flow test asks whether a company can pay its debts as they fall due. The balance sheet test asks whether its liabilities exceed its assets. A company can fail one and pass the other.

What is the difference between insolvency and liquidation?

Insolvency is the state of being unable to pay debts. Liquidation is a legal procedure where a liquidator realises the assets, pays creditors and the company is dissolved. Insolvency may lead to liquidation but they are not the same.

Does a company have to be insolvent to be wound up?

No. Members can choose to wind up a solvent company, for example when its business is finished. Insolvency is only required for procedures that depend on inability to pay debts.

What is administration in company law?

Administration is a procedure in which an administrator takes control of an insolvent company. The aim is to rescue it or get a better result for creditors than immediate liquidation.