Charities have noble aims and pursue worthy causes, but unfortunately, they are also at the mercy of market forces, economics, politics, and, ultimately, the generosity of their donors. If trustees and directors aren’t careful, the charity they are in charge of can slip into insolvency.
Charities face the constant challenge of insolvency in the same way as any traditional business operating in the UK. For this reason, trustees need to know when their charity is facing insolvency, and when they need to declare insolvency.
In this article, the expert team at Irwin Insolvency explains when a charity should declare insolvency, and what happens next.
When Does a Charity Become Insolvent?
For a charity – as with any business – insolvency occurs when debts can no longer be paid. A charity is deemed insolvent when its accounts are in the red, and when the money coming in no longer covers its expenses. Outstanding debts go unpaid, creditors begin demanding payments, and the charity must recognise that it’s no longer able to continue operating from a solvent position.
Insolvency can occur for a number of reasons, but for charities, insolvency commonly occurs due to a lack of funding. Charities rely on donations, either from the generous public, individual donors or from the government, in order to fund their charitable endeavors. If major sources of funding dry up, then the charity can become insolvent.
Like businesses, charities also have expenses. Increased operating costs or the increased cost of supplies or employment can cause charities to slide into insolvency. Charities can also be mismanaged by their trustees and directors, operations can be affected by economic and political forces, while unprecedented events – such as Covid-19 – can be absolutely disastrous for a charity’s funding.
Insolvency Tests for Charities
It’s the responsibility of a charity’s trustees and directors to ensure that they make informed financial decisions that are in the best interests of the charity. This involves not only securing funding and minimising expenses but also staying informed of the charity’s accounts and financial situation, so as to be aware of the likelihood of insolvency occurring and being able to act to stall or avoid it.
There are two primary tests that demonstrate if a charity is heading towards insolvency, or indeed if they already are insolvent. If a charity fails either of these two tests, then it may be deemed insolvent.
These two insolvency tests are:
- Cash flow test
- Balance sheet test
The first test is the cash flow test. This is a short-term test that shows if the charity has enough cash (through funds, donations, sales, etc.) coming into the accounts to cover the expenses that need to be paid. If the cash flowing in can’t cover costs, then the charity is insolvent and needs to make this known.
The second test is the balance sheet test. This is a longer-term test that looks at the overall value of a charity’s assets. If the value of the assets is worth more than their estimated costs and expenses, then the charity remains solvent. If the value of the assets is worth less than the estimated cost of expenses, then the charity is facing insolvency.
When Does a Charity Need to Declare Insolvency?
If a charity fails the cash flow test, they are unlikely to be able to pay their immediate bills unless they secure more funding. As soon as those bills go unpaid, then the charity has entered into a state of insolvency.
If a charity fails the balance sheet test, they aren’t necessarily insolvent at this point, as it’s a long-term test of finances. However, failing a balance sheet test is a good indication that the charity is heading towards insolvency and that its trustees need to act to avoid this.
Insolvency isn’t a legal process, however; it’s a state of being. This means a charity doesn’t need to declare insolvency to be insolvent. Rather, they are automatically insolvent as soon as they can’t pay their debts (and as soon as they’ve failed the cash flow test). A charity’s trustees should always declare when a state of insolvency has become apparent, and they should work as best as they can to become solvent again.
What Happens When a Charity Becomes Insolvent?
Once a charity is aware that it is facing insolvency or has already entered into a state of insolvency, the trustees have a number of options to consider. Because charities rely heavily on donations, it is possible that fundraising could secure the necessary cash to save the charity in the short term.
If this isn’t the case, then a charity faces similar insolvency measures that are applied to general businesses in the UK. These include the following procedures, which need to be instigated and overseen by licensed insolvency practitioners:
- Company Voluntary Arrangement (CVA)
It’s in the best interest of everyone involved that the charity is saved from insolvency, so it can continue working towards its chosen cause. This means that any form of liquidation – a total shutdown of the charity and the sale of its assets – is only ever a last resort. Before this has to happen, a charity can be placed into administration or it can come to financial agreements (usually in the form of CVAs) with its creditors.
It should also be noted that trustees and directors have varying degrees of responsibility, once insolvency has been declared. If a charity is incorporated, then it’s treated as an incorporated company. This means the trustees and directors are only liable for debts if they are proven to have deliberately acted against the interests of the charity. If a charity is unincorporated, then the trustees and directors may be liable for debts once insolvency has been declared.
Contact Irwin Insolvency Today for Your Free Consultation
With decades of experience providing charities across the United Kingdom with expert financial advice, our team of licensed insolvency practitioners can offer impartial expertise to help you through tough times.