The solvency test is a legal financial check that must be satisfied before a company does any of the following:
- 💸 Makes a distribution (like paying dividends),
- 🔄 Redeems or buys back its shares,
- 🔚 Amalgamates or reduces share capital.
📌 What Is the Solvency Test?
Under Section 57(1), a company passes the solvency test if both of the following conditions are met:
✅ (a) Liquidity Test – Can the Company Pay Its Debts?
The company must be able to pay its debts as they become due in the normal course of business.
This includes:
- Supplier payments
- Loan instalments
- Tax obligations
- Lease or rent commitments
- Any other debts that will fall due within the next 12 months
Practical Check:
Does the company have enough cash flow or liquid assets to meet short-term obligations?
✅ (b) Net Assets Test – Does the Company Have Positive Net Worth?
The value of assets must be greater than both:
- (i) The value of liabilities, and
- (ii) The company’s stated capital (i.e., the total value of shares issued and paid-up capital)
This is stricter than just having assets > liabilities. You must also cover your share capital with net assets.
🔍 Example:
XYZ (Pvt) Ltd has:
- Assets: Rs. 10 million
- Liabilities: Rs. 4 million
- Stated capital: Rs. 6.5 million
🧮
Assets (10M) > Liabilities (4M) ✅
Assets (10M) > Stated Capital (6.5M) ✅
✅ Solvency Test Passed
🧾 Section 57(2): How Should Directors Apply the Solvency Test?
The Board of Directors is responsible for determining solvency. The law requires directors to:
📊 (a) Use the Most Recent Financial Statements
Directors must base their decision on the most recent financial statements prepared in line with Section 151 of the Act.
This means the financials should:
- Be properly prepared (usually by a qualified accountant),
- Reflect a true and fair view of the company’s position.
👀 (b) Consider All Known Circumstances
Directors must also consider anything they know (or should reasonably know) that could affect the value of assets or liabilities.
Examples include:
- A large pending lawsuit (liability)
- Asset impairment (e.g. a factory damaged in a fire)
- Future cash inflows or outflows
- Market downturns or customer loss
🎯 You can’t rely solely on last year’s balance sheet if you know something material has changed since then.
⚖️ (c) Use Fair Valuation Methods
Directors may apply fair valuation or other methods to estimate asset and liability values if book value doesn’t reflect real worth.
Examples:
- Revaluing land at current market price (instead of outdated book value)
- Discounting future receivables
- Recognising bad debts not yet written off
This ensures that solvency is based on economic reality, not just outdated numbers.
⚠️ Why This Matters
✅ Applying the solvency test correctly protects:
- The company from making illegal payments or share transactions,
- Creditors from losing out,
- Directors from being held personally liable for decisions made on incorrect financial assumptions.
🧑💼 Key Takeaways for Business Owners & Directors
| Step | What to Do |
|---|---|
| 1️⃣ | Review the most recent audited or interim financial statements |
| 2️⃣ | Consider all known events affecting company finances |
| 3️⃣ | Use fair valuation if necessary to reflect true asset/liability values |
| 4️⃣ | Document the solvency analysis clearly in board minutes |
| 5️⃣ | If making a distribution, sign a solvency certificate and get auditor confirmation (as per Section 56) |
📬 Need Help?
For major decisions involving share transactions or distributions, always:
- Work with your chartered accountant,
- Consult your company secretary, and
- In complex cases, get advice from a corporate lawyer.
