Keeping Debtors Honest with a Solvency Opinion

Are you worried your business won’t receive what a liquidating creditor owes it? In most cases, liquidating companies come by their financially distressed situations honestly. But there’s always a chance that a debtor has made fraudulent transfers or taken other steps to hide assets from creditors. A solvency expert can help you and your legal counsel determine whether a liquidating business is capable of meeting its interest and repayment obligations.

How experts test the balance sheet

Solvency experts consider many issues when examining a business. But ultimately, the outcome of three tests enable an expert to determine solvency. The first is to assess the business’s balance sheet.

At the time of the transaction at issue, did the debtor company’s asset value exceed its liability value? Assets are generally valued at fair market value, rather than at book value. The latter is typically based on historic cost, and fixed assets (such as vehicles and equipment) that may be reduced by annual depreciation expense. But the balance sheet is just a starting point. Adjustments to balance sheet items may be needed so they more accurately reflect the fair market value of assets.

Cash flow considerations

The second test examines whether the business incurred debts that were beyond its ability to pay as they matured. The solvency expert analyzes a series of projections of future financial performance.

There are several possible scenarios. These include management’s growth expectations, lower-than-expected growth and no growth — as well as past performance, current economic conditions and future prospects. In the end, the expert should have some idea of the business’s cash-flow situation.

Assessing whether capital is adequate

The final test determines whether a debtor has adequate capital and is likely to survive in the normal course of business. Experts bear in mind reasonable fluctuations in the future. In addition to looking at the value of net equity and cash flow, they consider factors such as asset volatility, debt repayment schedules and available credit.

In general, experts consider companies solvent if they pass all three of these tests. When they complete an engagement, they issue a solvency opinion.

A specialized discipline

Solvency analysis is a specialized discipline that requires considerable knowledge and experience. Most business owners and attorneys aren’t necessarily capable of determining whether a debtor can pay — or whether it’s hiding something.

(This is Blog Post #1344)