The corporate insolvency test lives in section 123 of the Insolvency Act 1986. It asks a deceptively simple question: is the company “unable to pay its debts”? The answer changes almost everything about your position as a director.
Once the company fails the test, your duties shift from maximising shareholder value to protecting creditors (the Supreme Court settled that line in BTI v Sequana). Continuing to trade without facing the question is what section 214 wrongful trading liability is built to catch.
In our experience, directors come to us weeks or months after the test was first failed; that delay is what generates the personal liability.
Section 123 sets out four separate limbs, and the company only needs to fail one for the statutory test to be met. This guide walks through each limb, shows where directors typically miscalculate, and explains what the test means in the week-to-week operational reality of running a business that is under pressure but not obviously gone.
Failing the section 123 test is not an event that is announced. It is a state the company is in. And if you are a director, it is a state you are responsible for knowing about. Four consequences flow from the company being insolvent on the statutory test:
Your duties shift. The Sequana rule means once insolvency is likely, directors must have regard to creditor interests. As insolvency becomes more certain, that regard becomes more weighted, until it eclipses the shareholder duty entirely.
Section 214 wrongful trading exposure crystallises. If you keep trading past the point where there is no reasonable prospect of avoiding insolvent liquidation and you do not take every step to minimise creditor loss, you are personally liable to contribute to the estate for the increase in the deficiency caused.
Creditors can petition. A creditor owed more than £750 with an unpaid statutory demand after 21 days can present a winding-up petition. HMRC and factoring companies are the most common petitioners.
Transactions can be unwound. Preferences (section 239), transactions at undervalue (section 238), and avoidance of floating charges (section 245) all require, among other things, that the company was insolvent at the time. Failing the test is the switch that arms those provisions.
None of this requires a liquidator to agree. The test is objective. A court, an IP, or HMRC can conclude the company was insolvent on a given date after the event, and unwind, claim, or sue accordingly. Our licensed IPs run this analysis on a specific date, using the management information available at that date, which is the same exercise a court would conduct.
The Cash-Flow Insolvency Test: Section 123(1)(e)
The cash-flow test is the limb most directors hit first. The wording is short: the company is unable to pay its debts “as they fall due”. Short. But not as obvious as it reads.
The Supreme Court in Eurosail [2013] explained the scope: the test is commercial, not accounting. “As they fall due” means when payment is contractually required, not when the creditor happens to chase. A quarterly VAT liability of £40,000 not yet due is not a cash-flow failure today; an overdue £5,000 PAYE bill from three months ago, with no plan to clear it, is.
Four operational indicators together suggest cash-flow insolvency in practice. We use these as a quick diagnostic when we first review a company’s position:
Routine payments slipping. PAYE/VAT paid late two quarters running, not recovered. Supplier payment runs delayed past terms consistently, not once.
Creditor pressure arriving. Statutory demands, County Court claim forms, formal letters of claim, distraint visits. Each is evidence the cash-flow problem has reached the creditor’s threshold for action.
New-money reliance. The business is covering this month’s payroll out of next month’s VAT, or out of a director’s loan, or out of a facility drawn specifically to prop up operating cash. That is cash-flow failure being papered over.
Payment-date stretching with no plan to close it. Day sales outstanding creeping up, days payable outstanding creeping up further, working-capital gap widening month-on-month.
Directors often protest that they are “just in a tight month”. The test is not about a bad month; it is about the pattern. If the position has not closed in 90 days, the company is failing the cash-flow test, whatever the optimism in the board pack says. This is the pattern we see most often in distressed director cases: the tight month that never recovered.
The Balance-Sheet Insolvency Test: Section 123(2)
Section 123(2) asks whether the value of the company’s assets is less than the amount of its liabilities, including contingent and prospective liabilities. Where the cash-flow test captures timing problems, the balance-sheet test captures solvency-in-substance.
Eurosail is the leading authority. The Supreme Court held the test is not a simple accounting comparison of book values; it is whether the company has reached “the point of no return”. The court looks at:
Contingent liabilities, guarantees called or likely to be called, disputed tax assessments, product-liability claims, dilapidations on leased property.
Prospective liabilities, known obligations that will arise in the reasonably foreseeable future.
Realisable asset values, not book value. Fixed assets at auction value, stock at net realisable, receivables at likely-collected, intangibles at zero unless there is a buyer.
Time horizon, Eurosail rejected the idea that a temporary negative balance sheet automatically triggers the test. The question is whether the company can trade through it on a realistic view of future cash-flows.
For a growing business with heavy up-front investment, the balance-sheet test is usually not the problem; growth businesses often run balance-sheet insolvent for months without being in distress.
For a distressed business, it is often the limb that a liquidator relies on in avoidance claims, because a point-of-no-return finding on a particular date sets the clock for section 238, 239, and 245 lookbacks. If you have made payments to connected parties in the last two years, you need to know when your company crossed this line.
The Legal Action Limbs of the Insolvency Test
The first four limbs of section 123(1) give creditors formal evidence of insolvency that a court can act on without needing a full accounting enquiry:
Section 123(1)(a), unpaid statutory demand. A creditor owed more than £750 serves a statutory demand. If 21 days pass without payment, security, or a court-recognised compromise, the test is met. See our guide to the statutory demand.
Section 123(1)(b), unsatisfied execution of a judgment. A judgment debt with execution returned unsatisfied, typically an HCEO attempting enforcement and reporting no goods available.
Section 123(1)(c), Scottish extract registered decree or document of debt. The Scottish equivalent.
Section 123(1)(d), Northern Ireland equivalent.
These limbs are how creditors usually prove insolvency to support a winding-up petition. You do not need to wait for the final accounting enquiry, an unanswered statutory demand is enough.
The Consequences of Trading While Insolvent
Directors who trade on after the company has failed the section 123 test without taking structured steps to minimise creditor loss expose themselves on several fronts:
Wrongful trading, section 214. Personal contribution to the estate, measured by the increase in the company’s net deficiency from the date the director knew or ought to have known there was no reasonable prospect.
Misfeasance, section 212. Summary proceedings for breach of fiduciary duty, typically attaching to specific transactions rather than continued trading generally.
Preferences and undervalues. Transactions made while insolvent can be unwound. Paying connected-party creditors in preference to HMRC is the archetype.
Director disqualification, under the Company Directors Disqualification Act 1986, particularly schedule 1 conduct grounds. Disqualification runs from two to 15 years.
Personal-guarantee exposure. PGs typically become enforceable on the company’s insolvency. Your personal position may deteriorate rapidly once the company is demonstrably insolvent.
The legal exposure is one half. The commercial exposure, loss of goodwill, loss of supplier credit, loss of employee confidence, HMRC shutting down the PAYE scheme, tends to materialise faster than the legal claims, and it often forces the decision that directors are trying to defer.
Running the Insolvency Test Yourself, A Working Method
If you want an honest answer to whether your company is meeting or failing the section 123 test, a thirty-minute exercise with the management accounts and the sales ledger:
Pull every overdue creditor balance. Trade, HMRC (PAYE, VAT, CT), finance facilities, landlord, utilities. Total, by date overdue.
Pull the 90-day cash-flow forecast. Realistic receipts only, factored-in late payers, factored-in sales you have not yet invoiced.
Compare. Does projected cash cover the overdue total plus the 90-day run-rate outflow? If not, the cash-flow test is on the wrong side.
Write down asset realisable values. Stock at NRV, plant at forced-sale, debtors net of likely bad debt. Add contingent liabilities (called PGs, disputed tax, dilapidations).
Compare realisable assets to total liabilities. Negative? You are on the wrong side of the balance-sheet test too.
Document what you did, date it, and keep the file. If wrongful trading comes up later, the evidence that you looked at the test, on a specific date, with the management information you had, is the most important defence.
The point is not to reach the “right” answer. It is to show you took the question seriously and acted on the answer. Our recommendation: run this exercise quarterly and date the output. It is the simplest form of wrongful-trading defence available.
Your Next Step on the Insolvency Test
If you have run the working method above and the company is on the wrong side of either limb, you are past the point where reading articles is the right activity. A one-hour conversation with a licensed IP gives you the options: can the business be rescued through a CVA or administration, does a CVL make more sense, is there still time to turn it around without a formal process.
The earlier the conversation, the more live the options. We run that diagnostic call free and without commitment.
Call us free on 0800 074 6757 for a confidential review. We will run through the section 123 test with your numbers, tell you honestly where the company sits, and show you what each route looks like in practice. Nothing is charged until you instruct; the first call is purely diagnostic. Our advisers are licensed insolvency practitioners, not sales teams.
Insolvency Test FAQs
What is the insolvency test under section 123?
Section 123 of the Insolvency Act 1986 sets out when a company is “unable to pay its debts”. Four limbs: unpaid statutory demand above £750 for 21 days; unsatisfied execution of a judgment; the cash-flow test (cannot pay debts as they fall due); and the balance-sheet test (liabilities, including contingent and prospective, exceed assets). Failing any one limb means the statutory test is met.
How do I know if my company is cash-flow insolvent?
Look for overdue routine liabilities that are not closing, PAYE and VAT slipping past due dates two quarters running, supplier payments consistently beyond terms, reliance on new borrowing to cover payroll, stretching payment days with no plan to close the gap. A single bad month is not the test; a pattern that has not closed in 90 days is.
Can a temporary negative balance sheet be fatal?
Not automatically. The Supreme Court in Eurosail confirmed the balance-sheet test is whether the company has reached “the point of no return” on a realistic view of future cash-flows, not a simple accounting comparison.
Growth businesses often carry a negative balance sheet through their investment phase without meeting the statutory test. The distinction is whether the forward trajectory realistically resolves it.
What is wrongful trading and how does it connect to the insolvency test?
Wrongful trading (section 214) is civil liability on a director who continued to trade past the point where they knew, or ought to have concluded, that there was no reasonable prospect of avoiding insolvent liquidation, and did not take every step to minimise creditor loss.
The section 123 insolvency test is the factual backdrop: a company on the wrong side of it is where the wrongful-trading clock starts.
Does an unpaid statutory demand automatically mean insolvency?
For the purposes of section 123(1)(a), yes, if the demand is for more than £750, properly served, undisputed, and not paid, secured, or compromised within 21 days, the statutory test is met and the creditor can proceed to a winding-up petition. The company can apply to set the demand aside on genuine-dispute grounds, which buys time; ignoring the demand does not.
What should directors do if the insolvency test is met?
Take licensed insolvency-practitioner advice promptly, the same day, if creditor action is imminent. The options include CVA, administration, CVL, or (where the business is viable) informal restructuring.
The test being met does not mean the business cannot be saved; it means the decision about what to do is now urgent and needs structured input. Document the fact that you took advice on the date you did.
Methodology & Disclosure
This guide is written by the Company Debt editorial team and reviewed by licensed insolvency practitioners. Statutory references are to section 123 of the Insolvency Act 1986 and its surrounding machinery (sections 124, 127, 214, 238, 239).
Case references cite BNY Corporate Trustee Services v Eurosail [2013] UKSC 28 on the balance-sheet test and BTI 2014 LLC v Sequana SA [2022] UKSC 25 on the directors’ duty-shift at the approach to insolvency.
Company Debt’s licensed IPs advise on all corporate insolvency procedures and provide a free initial diagnostic review. The 0800 number is confidential; nothing is charged until a scope of work is agreed.
