The following three tests are used to determine solvency:
Balance Sheet Test – The balance sheet test determines if, the total fair value of the debtor assets which includes both tangible assets and intangible assets, is greater than the total amount of the debtor liabilities at the time of the transaction. It can be performed on either a going-concern or liquidation basis. Generally, the premise of value is as a going concern business enterprise.
The valuation analyst estimates the fair value of the debtor corporation assets, including tangible assets such as real estate and other property, financial assets, and intangible assets. A similar exercise is conducted on the debtor corporation liabilities, which includes all current liabilities, long-term liabilities, and any contingent liabilities including any new debt related to a proposed corporate transaction.
The value of the firm’s assets is equivalent to its Enterprise Value which can be determined using standard valuation approaches and methodology.
Finally, the analyst will subtract the amount of the total liabilities from the fair value of the total assets. The balance sheet test is “passed” if the fair value of the debtor corporation total assets is greater than the amount of the debtor corporation total liabilities.
Cash Flow Test – This test is used to determine whether the company had sufficient cash flows to pay its debts as they mature as of the valuation date(s). The test involves the matching of sources of cash to its obligations as they mature. It is also referred to as the ability-pay solvency test or equitable solvency test. It answers a really important question: Whether the company can reasonably be expected to pay its debts as the payments on such debts become due.
In order to perform this test, the debtor’s expected cash flow is projected for any proposed financing for the repayment period. The cash flow test analysis matches the incoming sources of projected cash flow to the repayment of both principal and interest debt obligations. The analysis also is conducted for the current cash flows available to meet debt obligations. The analysis is completed by estimating any excess cash available on the transfer date, the available cash flow during the projection period, and the availability of any unused credit commitments.
If the debtor company can pay its projected debt obligations from any one of the three aforementioned sources of cash, then the cash flow test is “passed”. A sensitivity analysis to “stress test” the various cash flow projection variables is also needed. This helps the analyst determine whether the debtor can honor the debt payments under alternative operating conditions.
Capital Adequacy Test As the name signifies, this test determines whether the company had sufficient capital as of the valuation date(s). It is also known as the reasonable capital test. The test determines if the company has sufficient capital to pay its operating expenses, principal and interest for a debt obligation and contingent liabilities and capital expenses. The objective to the test is to determine if the business can sustain fluctuations in business conditions for future periods after the transfer date. The test requires an analysis of the short term sources and uses of funds for the four fiscal quarters after the transfer date. Typically, the following scenarios are covered in the analysis:
- The debtor company’s “most likely” estimate scenario of future financial and operational performance
- No change scenario from the recent corporation historical financial performance
- Reasonable variation scenarios in the corporation revenue growth rate and profit margins
The capital adequacy test is “passed” if the corporation is expected to have sufficient cash on hand to pay its (1) operating expenses, (2) capital expenditures, and (3) debt repayment obligations.