Determining Insolvency

Distressed companies are those facing financial crises not resolvable without a considerable recasting of the firm's operations, structures and finance. This can be brought about through a company's failure to make a substantial payment of principal or interest to a creditor. Distress can also be seen in terms of financial ratios, for example in terms of liquidity and longer-term solvency. The basic and most prevalent forms of corporate distress assessment are the cash flow and the balance sheet tests, which apply both to going concern and break up (insolvency) valuation. In terms of break up valuation, under the cash flow test, a company is insolvent when it is unable to pay its debts as they fall due. Under the balance sheet test, the entity is insolvent if the book value of its assets, as listed on the conventional balance sheet, is less than its reported liabilities. The notions of asset exchangeability/liquidity and time prospect of sale are of great importance,