A test required by the Companies Act which requires the directors of a company to assert that the company can meet all its expenses out of its incomes for the next 12 months (liquidity) and that its assets are more than its liabilities (solvency). This test must be conducted before the paying of a dividend, a share buy-back or a loan to a director.
Section 4 of the Companies Act, 2008 lays out the requirements of the Solvency and Liquidity Test that must be applied by directors of companies when entering into certain transactions or commencing with certain actions. This test adopts an approach of stopping companies from trading recklessly in an insolvent situation by requiring that the Company be not only liquid, i.e. able to pay its debts as they become due in the ordinary course of business, but also that it is solvent at the time of the transaction. The definition of solvency stipulates that the assets of a company, fairly valued at the time of the transaction, must be equal to or exceed the liabilities of a company, fairly valued at the time of the transaction.
The Solvency and Liquidity Test must be applied by the directors of the Company when contemplating the following transactions:
- Financial assistance for the acquisition or subscription of securities;
- Financial assistance provided to directors and prescribed officers and/or to certain related and inter-related parties, this is particularly relevant to loan account transactions between entities and directors;
- Dividends and distributions;
- The issue of capitalisation shares;
- Share buy-backs;
- Amalgamations or mergers.
Failure by the board to adhere to this test will result in the directors at fault being held personally liable for any resulting damage caused to the Company. Even though the Companies Act, 2008 has reduced the number of offences that will result in criminal sanctions, this has not relieved directors of any personal liability risk. It is therefore critical that directors apply their minds when contemplating the above transactions, as well as other transactions that could impact on the Company’s solvency and liquidity.
Liquidity & Solvency Ratio
Liquidity ratios and solvency ratios are tools investors use to make investment decisions. Liquidity ratios measure a company’s ability to convert its assets to cash. On the other hand, solvency ratios measure a company’s ability to meet its financial obligations. Solvency ratios include financial obligations in both the long and short term, whereas liquidity ratios focus more on a company’s short-term debt obligations and current assets.
Liquidity ratios gauge a company’s ability to pay off its short-term debt obligations and convert its assets to cash. It is important that a company can convert its short-term assets into cash, so it can meet its short-term debt obligations. A healthy liquidity ratio is also essential when the company wants to purchase additional assets.
One common liquidity ratio is the current ratio. The current ratio measures a company’s ability to meet its short-term debt obligations. It is calculated by dividing its current assets by its current liabilities. Generally, a higher current ratio indicates that the company can pay off all its short-term debt obligations.
In contrast to liquidity ratios, solvency ratios measure a company’s ability to meet its total financial obligations. The solvency ratio is calculated by dividing a company’s net income and depreciation by its short-term and long-term liabilities. This indicates whether a company’s net income can cover its total liabilities. Generally, a company with a higher solvency ratio is a more favourable investment.
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