Quick answer
Solvency means a business can pay all its debts as and when they fall due. Under the Corporations Act, that is the legal definition for companies, so the main test is cash flow rather than whether assets outweigh liabilities. Directors must keep checking it, pass a solvency resolution each year after the ASIC annual review in most cases, and confirm it to lenders in loan documents.
Key points
- Legally defined as being able to pay all debts as and when they become due
- Courts focus on cash flow; the balance sheet is supporting evidence
- Most companies must pass a solvency resolution within two months of their ASIC review date
- Loan agreements usually include a promise that the borrower is solvent
A solvent business can pay what it owes, on time, as each bill comes due. That sounds like plain common sense, and it is, but in Australia it’s also a precise legal test with real consequences for company directors and for anyone lending to them.
What is the legal test?
Section 95A of the Corporations Act says a person is solvent only if they can pay all their debts as and when they become due and payable. Anyone who fails that test is insolvent. The definition applies to companies and is the yardstick courts use when deciding whether directors traded while insolvent.
Two ways of looking at it come up:
| Test | Question asked | How courts use it |
|---|---|---|
| Cash flow test | Can the business meet its debts as they fall due, using cash it has or can realistically raise in time? | The primary test |
| Balance sheet test | Do total assets exceed total liabilities? | Supporting evidence, not decisive alone |
The cash flow test is what catches people out. A company can own a valuable warehouse and still be insolvent if it can’t pay suppliers, staff and the ATO on time. Equally, a company with a weak balance sheet may be solvent if it has reliable cash coming in and supportive lenders.
The yearly solvency resolution
Each year ASIC sends a company an annual statement tied to its review date. Within two months of that date, directors must pass a solvency resolution: a formal view on whether there are reasonable grounds to believe the company will be able to pay its debts as they fall due. Companies that lodged a financial report with ASIC in the 12 months before the review date are exempt.
A negative resolution has to be notified to ASIC within seven days. So does a failure to pass any resolution in the two-month window. Many small company directors tick this box without a second thought. It’s worth pausing on, because it’s a yearly prompt to look honestly at the next few months of cash flow.
Why solvency matters when you borrow
You promise it in writing. Most business loan agreements include a statement that the borrower is solvent, and insolvency events are listed as defaults. Lenders take this seriously.
Lenders test it, in their own way. They look at liquidity measures like the current ratio, overdue tax, arrears with suppliers and dishonours on bank statements. A large ATO debt isn’t automatically a solvency problem if there’s a payment plan and the business is otherwise paying its way.
Finance can restore it. Where the trouble is that wealth is tied up in property, converting some equity into cash can put a business back in a position to meet its debts. See our page on home equity business loans, or ask us whether property could help.
Worked example: asset-rich, cash-poor
Here’s an illustrative case. A Perth engineering company owns its workshop, valued at $1.4m with a $500,000 mortgage. It’s owed $260,000 by customers, but a major client is paying 90 days late. Meanwhile it has $180,000 due to suppliers and the ATO within the month and $40,000 in the bank.
On paper the company is comfortably in surplus. On the cash flow test, it’s in trouble unless it can raise cash quickly. The directors seek advice, agree an ATO payment arrangement, and take a second mortgage over the workshop for $150,000 to clear suppliers while the late client pays. Because the funding fits a believable plan and the debt is backed by real security, it supports solvency rather than masking a deeper problem. A cash runway calculator is a quick way to see how many weeks you have before a gap becomes urgent.
Related terms
- Insolvency: failing the solvency test, and what follows
- Net worth: assets minus liabilities, the balance sheet view
- Working capital: the short-term buffer that keeps a business solvent
- Liquidation: where a company that can’t recover ends up
Keeping the business on solid ground
If the numbers show a tight few months ahead, acting early gives you more choices. We regularly help directors use property, receivables or equipment to free up cash while there’s still time to plan properly.
Our short form takes about a minute to complete. Enquiring doesn’t put a credit check on your record, and we won’t scatter your details across a crowd of lenders. Someone on our team works through your situation personally and then gives you a call. The more accurately you describe your debts and assets, the faster we can tell you what’s realistic.
Frequently asked questions
What is the difference between solvency and liquidity?
Liquidity is about how quickly you can turn assets into cash to meet short-term bills. Solvency is the broader legal question of whether you can pay all your debts as they fall due. A business with poor liquidity is at risk of becoming insolvent if it can't fix the shortfall.
Can a company with more assets than debts be insolvent?
Yes. If the assets can't be turned into cash in time to pay debts when they're due, the company may fail the cash flow test. Property or specialised equipment that would take months to sell doesn't pay this month's suppliers.
What is a solvency resolution?
A decision by the directors, made within two months after the company's annual review date, about whether there are reasonable grounds to believe the company can pay its debts as they fall due. Companies that lodged a financial report with ASIC in the previous 12 months don't need to pass one.
What happens if directors pass a negative solvency resolution?
The company must notify ASIC within seven days. A negative resolution is a strong signal to get advice from a registered liquidator or insolvency adviser about the options, which may include restructuring or administration.
Is borrowing to stay solvent allowed?
New finance can be part of a sensible plan, for example turning property equity into cash to pay a tax debt. Directors still need to be confident the new debt can be repaid. Borrowing that only delays an inevitable failure can make things worse, so get advice if in doubt.