“Our business is not insolvent,” remarked Scotty, “we have plenty of room in the limit of our debtor factoring facility and we made a small profit last year.”
Let me know what you think about this in the comments, because I have heard it 3 times just this week. Do I think this is right? If working capital is already poor, then no.
Scotty refers to two indicia: (1) ability to draw down more from factoring; and(2) profitability.
1. Factoring – even if there was a surplus, it’s not relevant to the question of solvency. Why?
– by factoring, the company is reducing accounts receivable and exchanging that current asset for a slightly reduced other current asset (ie cash) and a current liability (ie the loan to the factoring company);
– this exchange is akin to just exchanging short-term obligations, without improving cash flow (Harrison v Lewis; ASIC v Edwards); and
– the real kicker: in contrast to an overdraft facility, the company would actually have had to sell more products/services than it actually did to utilise the surplus (in hindsight). That’s impossible!
2. Profitability – courts recognise that big profits, which could foreseeably pay all debts in the reasonable future, are a sign of solvency (Quick v Stolan, 379-380).