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Why did the 2008 Companies Act make liquidity tests compulsory?

by , 20 April 2015
The 2008 Companies Act (Co's Act) made liquidity tests compulsory to ensure companies are cash healthy before and after certain transactions.

But when do you have to perform theM/ Here's a checklist that shows four instances where liquidity tests are compulsory.

A company must perform a liquidity test before it:

- Provides financial assistance to people so they can buy the company's shares (Section 44 of the 2008 Co's Act);

- Makes loans to directors (Section 45 of the 2008Co's Act);

- Declares a dividend (Section 46 of the 2008 Co's Act);

- Merges with another company (Section 113 of the 2008 Co's Act).

Basically, the Act wants to avoid a situation where, for example, a company declares a dividend but after it pays the shareholders, it has no more money left to pay its water, lights, staff's salaries, etc.

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When do you ACTUALLY need to perform a liquidity test?

Liquity tests show if your company will be able to meet all its debts after it provides the financial assistance to the director. If it can, then your company is liquid.

Example
Lucy Smith is a director of Lucy Smith Language Services (Pty) Ltd, which provides editing, writing, web design and translation services. The company's annual turnover is R1 million. Every November, Lucy buys 10 Christmas cakes from the local Girl Guide troop at R1 000 each.

This year, the leader of the troop came round when Lucy wasn't in the office. Anne, her PA, phoned her to ask what she should do. Lucy told her to take R10 000 out of petty cash to give to the girl guides and that she would replace it the next day. Technically, Lucy Smith Language Services (Pty) Ltd has provided their director with financial assistance.

To see if your company's liquid, do a cash flow forecast. Creating a cash flow forecast is really the only way you can see if your company's liquid and has enough cash to pay its day-to-day expenses.

Keep in mind that the financial statements don't show which assets can be readily turned into cash and at what cost, or when you can expect to get more cash. Only a cash flow forecast can tell you this.

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