Cash flow and balance sheet tests
The cash flow test very simply put is the ability of a company to pay off their debts as they are liable to pay them; i.e. As soon as they are indebted they already have generated the money to pay it off immediately. A company will prove to be insolvent if and when the futuristic calculations prove it to be incapable of paying their debts. In case, a company is able to pay off their debts or bills for the first two months and after those, it is still considered insolvent. Hence, the cash flow insolvency test will be a futuristic calculation of debts and cash inflows based on the current trends of both e.g. If a company is earning $100,000 and has debts of $50,000 going out every month, the debts will increase to $60,000 in a month’s time making the company insolvent (Arner et al., 2006).
The balance sheet test is somewhat similar to the cash flow test but instead of calculating futuristic cash inflows, it focuses on probabilities of increase or decrease in liabilities and cash flows. Hence, the entire balance sheet test is based on the perspective inflows and outflows of a company. If and when the difference between the cash inflows and cash outflows is negative, then the company is considered to be insolvent. It is important to note here that only a handful of companies will measure up to being solvent after the balance sheet insolvency tests are complete (Arner et al., 2006).
Between the cash flow and balance sheet test, the cash flow test is a lot more accurate to measure a company’s insolvency as it considers the tangible inflows and outflows to determine a company’s financial standing i.e. The cash flows that the company is already recording and will continue to record in the future as well. The balance sheet test on the other hand considers the perspective cash flows, i.e. those cash flows that might possibly occur in the future, which leaves a sense of unpredictability to the company’s financial strength. Hence, the cash flow test is better and much more accurate.
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