World Turned Upside Down

In the "insolvency zone," creditors exert a strong pull that often throws CFOs off balance.

Delaware law sets out two tests for determining insolvency. In the balance-sheet test, a company is insolvent if liabilities exceed assets, with no reasonable prospect that the business can be continued. The cash-flow test says a company is insolvent if it is unable to meet maturing obligations as they fall due in the ordinary course of business. Neither standard is definitive. General Motors’s liabilities have exceeded its assets by tens of billions of dollars for more than five reporting periods: Does that mean the company is in the zone of insolvency? Insolvency is often clear only in the rear-view mirror.

“[Asset] valuations right now are so ridiculous, you could venture to say many companies are in the zone of insolvency and they don’t even know it,” says William Lenhart, national director of restructuring at BDO Consulting. If a company is in the middle of a quarter and asset values are fluctuating wildly, the fair value of its assets and liabilities would be hard to pin down. Certain items, such as intangible assets, could be worth nothing if a company is liquidated. Other assets might be too illiquid for a company to pay its bills.

And how far behind on its debt payments does a company have to be to be considered insolvent? The prospect of recovery is one way to frame the question. “Are there reasonable expectations that the shareholder is money-good?” asks Jim Fogarty, a managing director at Alvarez & Marsal. “If a reasonable read on the future shows positive value for shareholders — and liquidity — the CFO still needs to be concerned about them. If not, he has to start thinking about creditors.”

The due diligence for an insolvency test is similar to what auditors perform for a going-concern opinion. Recurring operating losses, negative cash flow, adverse key financial ratios, payables growing in number and aging, denial of trade credit — all are negative indicators. But a qualification on a going-concern opinion doesn’t equal insolvency; a company that earns a qualification could be solvent for months. (Studies show that only half of firms that go bankrupt earn going-concern opinions prior to bankruptcy.)

What’s more, a company’s P&L might belie the fact that the business is on the runway to bankruptcy. When Lindenmuth was hired by Amcast Industrial Corp., a manufacturer of aluminum wheels for cars, after the company emerged from Chapter 11, the near-term financials looked stable. But the auto industry grants parts contracts two years in advance, and during Amcast’s period of distress, carmakers hadn’t awarded it parts contracts for their new models. So the order pipeline was set to evaporate in a year’s time. “[Were we] right then in the zone of insolvency?” asks Lindenmuth. “Sometimes you can look far ahead [to bankruptcy], other times it’s sudden.” Amcast eventually liquidated.

Dealing with Denial

Once management determines insolvency to be an issue, it should test for it regularly, says BDO’s Lenhart. But it isn’t just the numbers that trigger the expansion of fiduciary duties. If a company hires a workout firm, an investment banker, or an attorney because of its lack of liquidity, “it needs to be prudent about its practices from that point,” says Sheila Smith, a principal at Deloitte Financial Advisory Services.


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