How to determine the insolvency status of the company in the insolvency proceedings

The Insolvency Law in Spain requires companies in a status of insolvency to apply for insolvency proceedings. In other words, those companies that cannot regularly fulfil their payment obligations have a deadline of two months to file their application.

Given the ambiguous nature of the concept of status of insolvency, we will delve throughout this article into its most relevant aspects from a legal and financial point of view, as well as the nuances and main consequences in the insolvency proceedings.

Revealing facts of a possible insolvency

Under the concept of revealing facts, the Insolvency Law accurately regulates a series of assumptions that can help to identify, unequivocally, when an insolvency status exists in a company, namely when:

• The enforcement of the seizure against the debtor does not result in enough free goods for payment
• There is a widespread breach of payment obligations by the debtor
• There are already foreclosures that affect the debtor’s assets
• In the event of the debtor’s asset stripping or the hasty or ruinous liquidation of his assets
• Finally, the general failure to comply with enforceable tax obligation payments, social security, or salary contributions during a period of three months.

The financial concept of insolvency

At a financial level, several accounting formulas can predict the possible status of insolvency of a company. Due to their high success rate, the two most commonly used are:

Acid test

This ratio indicates the solvency/liquidity of the company in the short term, comparing its main short-term figures: the current assets (minus stocks) with the current liabilities.

Acid test = Current assets – stocks / current liabilities

If the result is lower than 1, the current liabilities are excessive and thus a clear indicator of a possible insolvency situation, given the company’s lack of liquid assets to meet its short-term obligations.

Altman Z-score

While not infallible, it is one of the formulas most widely used. It consists of the following calculation:

Altman Z-score = 1.2 * T1 + 1.4 * T2 + 3.3 * T3 + 0.6 * T4 + 1.0 * T5

In this formula:

T1 = (Working capital / Total assets)

T2 = (Retained profits / Total assets)

T3 = (EBITDA / Total assets)

T4 = (Market capitalisation / Total Debt)

T5 = (Net income / Total assets)

After the calculation:

• If the result is above 3, the company would present no probability of bankruptcy
• A result between 2.7 and 2.9 would be considered a cautionary zone
• If the result is between 1.8 and 2.7, it would be in the warning zone
• A result below 1.8 would mean an imminent bankruptcy

Once the state of insolvency of the company is determined, it will be necessary to analyse the elemental aspects and the deadlines on how to apply for the insolvency proceedings as set out in Article 5 of the Insolvency Law.

Manuel Álvarez-Sala & José María Mesa

If you have any doubts about how to determine the state of insolvency of your company,