While both tests are useful in establishing a company’s financial health, the cash flow insolvency test looks at the short-term position, while the balance sheet test takes a long-term view.
Cash flow insolvency - There will be many warning signs that a company is cash flow insolvent, from being unable to pay its bills, through to creditors threatening further action and an inability to obtain additional credit. A cash flow insolvent company will find it increasingly difficult to continue to trade and its directors are likely to be all too aware of the precarious position it is in.
Balance sheet insolvency - A company which is balance sheet insolvent may be able to meet its monthly liabilities and other overheads with ease; due to this, balance sheet insolvency can go undetected for some time. This type of insolvency is often caused due to increased business debts even if this is manageable on a month-to-month basis.
While balance sheet insolvency may not seem as serious as cash flow insolvency at first glance, creditors can still take action to wind the company up if they have reason to believe it is insolvent. Balance sheet insolvency threatens the long-term viability of the company, and if assets begin to decline in value without liabilities being significantly reduced, the company can quickly be taken past the point of rescue.