The Difference between a Cash Flow Test and a Balance Sheet Test - Essay Example

Corporate flow insolvency refers to the lack or the inability of any debtor to pay debts. Cash flow insolvency refers to the lack of liquidity used in the payment of debts. These are the debts that fall due. Balance sheet insolvency occurs when there are negative net assets. This is where liabilities exceed assets. Insolvency is equal to bankruptcy. It, therefore, acts as a determination for any corporate insolvency. Its determination is by a court f law. It also has resulting legal orders that are intended to resolve any form of insolvency.

Any business can be cash-flow insolvent. However, it can be referred to as a balance sheet solvent. This is when it holds illiquid assets. This is particularly against any form of short-term debt that it often cannot immediately realize if called upon to do so. Any business can have negative net assets. They show on the balance sheet but can still be referred to be cash-flow insolvent. This is if the ongoing revenue can meet the debt obligations. This, therefore, avoids default. This is for instance if it holds any long-term debt. Many corporate companies operate in this state (Keay 2008).

Bankruptcy refers to legal status. It is the legal status of an insolvent corporate organization or a person. This is when someone cannot repay debts that they owe to the creditors. In several jurisdictions, bankruptcy is often imposed by a specific court order. A court order initiation is often by a debtor. This marks the beginning of a corporate organization’s insolvency. A balance sheet test includes prospective and contingent liabilities. This is always confusing mainly because if someone takes this definition in the literal form, then there will be few companies. However, after taking into account the future rents due then they are solvent. For simplicity's sake, one has to assume that if any prospective liabilities, for example, rent generate positive cash flows instead of cash outflows then a prospective liability needs not to be taken into any form of consideration. If the reverse however is true, then one must include a prospective liability. A cash flow insolvency test on the other hand contains flexible and highly fact-sensitive futurity requirements.