Contact us whenever you need it!

+1 855 997 0206

Contact hours: Mon-Fri 8am - 10pm ET

LEGAL DICTIONARY

Insolvency

What Is Insolvency?

The term insolvency refers to a temporary period when an individual or an entity cannot meet their financial obligations. Typically, an insolvent person or corporation contacts their creditors to work out a restructured payment plan.

According to the IRS, a person or company is insolvent when their total liabilities exceed their total assets. The causes of insolvency often include poor financial management, reduced cash flow, or an unexpected increase in expenses.

How Is Insolvency Different From bankruptcy?

While insolvency can sometimes lead to bankruptcy, the two terms describe two different financial states. Insolvency is a temporary and often repairable state of financial distress. Bankruptcy, which involves the court, can result as a consequence of unresolved insolvency.

Insolvent individuals or entities can get back on track by selling assets, borrowing money, cutting expenses, renegotiating debt, or allowing another company to handle the debts in return for control of their products or services.

On the other hand, an individual or entity declares bankruptcy in a court of law. By doing so, the person or company states that they cannot pay their debts. The court then decides how to use any remaining assets to pay creditors and erase debts they cannot pay. Bankruptcy damages the debtor’s credit rating for years. It also remains part of the debtor’s permanent financial record.

What Causes Insolvency?

Although there may be many contributing reasons for insolvency, they all relate to poor financial decisions and the failure to address them. Depending on your legal business structure, here are the most common contributing factors:

  • Limited funding
  • Unstable cash flow
  • Excessive borrowing
  • Declined sales
  • Over-dependence on one customer
  • Underestimation of the competition
  • Over-reliance on one employee
  • Poor expansion strategy

Insolvency can also happen due to events both within and beyond our control. Some businesses may point to climate-related or supply chain issues as contributing to their insolvency.

Sometimes medical expenses due to an accident or health problems can contribute to insolvency. However, there are warning signs that precede insolvency. These warning signs include:

  • Consistently being late in paying bills and other debts
  • Delaying paying employees
  • Using debt to pay off other debts
  • Maintaining a minimum bank balance
  • Selling non-cash assets to pay financial obligations
  • Using maximum credit lines
  • Seeing a high employee turnover rate
  • Losing previously loyal service providers

What Are The types Of Insolvency?

The two main types of insolvency are: cash-flow insolvency and balance-sheet insolvency.

Cash flow insolvency. In a cash flow insolvency (sometimes called a negative cash flow), a company or individual has a shortage of cash. Although the deficit might be temporary, it means the entity is unable to pay their operational bills and other debts.

Another way to look at this situation is the current liabilities exceed current liquid assets.

Balance sheet insolvency. An entity’s balance sheet is a complete list of assets and liabilities. When the balance sheet reveals that overall liabilities exceed the fair valuation of the total assets, the organization is insolvent.

What Are Some Examples of Insolvency?

An individual or business may become insolvent if they are unable to pay money owed to vendors or maintain loan payments. Here are two examples of companies that experienced insolvency and were able to turn things around.

Apple: In 1997, Apple, one of the world’s largest and most successful companies, was experiencing insolvency and was on the verge of bankruptcy. Microsoft saved the company with a $150 million investment. Over the years, experts have speculated that Microsoft made a move to avoid regulators regarding Microsoft as a monopoly.

Global Brands Group USA: Global Brands USA (an apparel company that sells clothing to major brands such as Macy’s, T.J. Maxx, Costco, etc.) was hit hard by the pandemic. In March 2021, the company reported sales had fallen by nearly 45 percent. The company sold off Aquatalia, other brands, and other assets as part of its efforts to remain solvent.

How To Handle Insolvency

As you can see from the previous examples, although insolvency can lead to bankruptcy, it can sometimes be reversed. Here are some steps to getting back on firmer financial footing.

  • Negotiate with creditors
  • Appoint an administrator
  • Deal with cash flow challenges through prompt invoicing and debt recovery methods
  • Minimize further borrowing
  • Trim inventory
  • Reduce liabilities
  • Liquidate assets
  • Reduce overhead expenses and wage costs
  • Only accept orders you can fill

Insolvency is not the end of a company, but it is a warning call to make a business financially sound.

Helpful Resources:

Wall Street Mojo - Insolvency

Investopedia - Insolvency Definition

Fundsnet Services - Insolvency: Definition and What Is It and What Causes It?

Cornell Law - Insolvency Definition

Internal Revenue Service - What if I am insolvent?

Debt.org - Differences Between Insolvency and Bankruptcy

What Is Insolvency?

The term insolvency refers to a temporary period when an individual or an entity cannot meet their financial obligations. Typically, an insolvent person or corporation contacts their creditors to work out a restructured payment plan.

According to the IRS, a person or company is insolvent when their total liabilities exceed their total assets. The causes of insolvency often include poor financial management, reduced cash flow, or an unexpected increase in expenses.

How Is Insolvency Different From bankruptcy?

While insolvency can sometimes lead to bankruptcy, the two terms describe two different financial states. Insolvency is a temporary and often repairable state of financial distress. Bankruptcy, which involves the court, can result as a consequence of unresolved insolvency.

Insolvent individuals or entities can get back on track by selling assets, borrowing money, cutting expenses, renegotiating debt, or allowing another company to handle the debts in return for control of their products or services.

On the other hand, an individual or entity declares bankruptcy in a court of law. By doing so, the person or company states that they cannot pay their debts. The court then decides how to use any remaining assets to pay creditors and erase debts they cannot pay. Bankruptcy damages the debtor’s credit rating for years. It also remains part of the debtor’s permanent financial record.

What Causes Insolvency?

Although there may be many contributing reasons for insolvency, they all relate to poor financial decisions and the failure to address them. Depending on your legal business structure, here are the most common contributing factors:

  • Limited funding
  • Unstable cash flow
  • Excessive borrowing
  • Declined sales
  • Over-dependence on one customer
  • Underestimation of the competition
  • Over-reliance on one employee
  • Poor expansion strategy

Insolvency can also happen due to events both within and beyond our control. Some businesses may point to climate-related or supply chain issues as contributing to their insolvency.

Sometimes medical expenses due to an accident or health problems can contribute to insolvency. However, there are warning signs that precede insolvency. These warning signs include:

  • Consistently being late in paying bills and other debts
  • Delaying paying employees
  • Using debt to pay off other debts
  • Maintaining a minimum bank balance
  • Selling non-cash assets to pay financial obligations
  • Using maximum credit lines
  • Seeing a high employee turnover rate
  • Losing previously loyal service providers

What Are The types Of Insolvency?

The two main types of insolvency are: cash-flow insolvency and balance-sheet insolvency.

Cash flow insolvency. In a cash flow insolvency (sometimes called a negative cash flow), a company or individual has a shortage of cash. Although the deficit might be temporary, it means the entity is unable to pay their operational bills and other debts.

Another way to look at this situation is the current liabilities exceed current liquid assets.

Balance sheet insolvency. An entity’s balance sheet is a complete list of assets and liabilities. When the balance sheet reveals that overall liabilities exceed the fair valuation of the total assets, the organization is insolvent.

What Are Some Examples of Insolvency?

An individual or business may become insolvent if they are unable to pay money owed to vendors or maintain loan payments. Here are two examples of companies that experienced insolvency and were able to turn things around.

Apple: In 1997, Apple, one of the world’s largest and most successful companies, was experiencing insolvency and was on the verge of bankruptcy. Microsoft saved the company with a $150 million investment. Over the years, experts have speculated that Microsoft made a move to avoid regulators regarding Microsoft as a monopoly.

Global Brands Group USA: Global Brands USA (an apparel company that sells clothing to major brands such as Macy’s, T.J. Maxx, Costco, etc.) was hit hard by the pandemic. In March 2021, the company reported sales had fallen by nearly 45 percent. The company sold off Aquatalia, other brands, and other assets as part of its efforts to remain solvent.

How To Handle Insolvency

As you can see from the previous examples, although insolvency can lead to bankruptcy, it can sometimes be reversed. Here are some steps to getting back on firmer financial footing.

  • Negotiate with creditors
  • Appoint an administrator
  • Deal with cash flow challenges through prompt invoicing and debt recovery methods
  • Minimize further borrowing
  • Trim inventory
  • Reduce liabilities
  • Liquidate assets
  • Reduce overhead expenses and wage costs
  • Only accept orders you can fill

Insolvency is not the end of a company, but it is a warning call to make a business financially sound.

Helpful Resources:

Wall Street Mojo - Insolvency

Investopedia - Insolvency Definition

Fundsnet Services - Insolvency: Definition and What Is It and What Causes It?

Cornell Law - Insolvency Definition

Internal Revenue Service - What if I am insolvent?

Debt.org - Differences Between Insolvency and Bankruptcy