Business insolvency occurs when a company lacks the assets to settle its debt payments to lenders as they become due. This can happen in any number of ways and may be the first step towards bankruptcy for a business.
Below, we talk about what you need to know about insolvency, steps you can take to bring your small business out of insolvency, and how insolvency compares to illiquidity and bankruptcy.
Key Points
• Insolvency occurs when an individual or business cannot meet its financial obligations as they come due or when liabilities exceed assets.
• Insolvency is a financial state; it’s not the same as bankruptcy, which is a legal process triggered by insolvency.
• There are two main types: cash flow insolvency, where a debtor cannot pay debts on time; and balance sheet insolvency, where liabilities exceed the value of assets. Technical insolvency is another name for balance sheet insolvency.
• Insolvency can be addressed through debt restructuring, asset liquidation, or legal bankruptcy proceedings. Early action and negotiation with creditors can often prevent formal bankruptcy.
• Insolvency affects creditworthiness, business operations, and stakeholder confidence. For businesses, resolving insolvency efficiently is critical to maintaining operations or facilitating an orderly closure.
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What Is Insolvency?
The meaning of insolvency isn’t always clear. People in business define insolvency as a state of financial distress in which an individual or company cannot repay the debts they owe. For example, a business may become insolvent if it’s unable to keep up with monthly payments due on their small business loans or money owed to vendors for goods and services they have already received.
Often being insolvent means bankruptcy is on the horizon, but insolvency by itself is not the same thing as bankruptcy. Before an insolvent company gets involved in any legal proceedings, they will likely engage in informal negotiations with creditors, such as setting up alternative payment arrangements.
Signs a Business May Be Approaching Insolvency
The best way to see if a business is on the way to insolvency is to examine the assets and liabilities on the balance sheet.
But other developments may also indicate a business is running into trouble. Those might include:
• Issues with revenue and cash flow: If sales and revenue are declining (because customers pay late, for example), profit margins are likely to fall as well. The imposition of cost controls, such as freezing executive pay, may be another hint.
• High staff turnover: Personnel issues sometimes indicate — or accelerate — future insolvency. A high rate of employee turnover, especially of key employees, may suggest they have doubts about the company’s future. Also, recruiting replacements or hiring temps to fill open roles is likely to be expensive.
• Difficulty in borrowing money: If the company has reached its borrowing limits, with company overdrafts maxed out and lenders refusing to extend financing, insolvency may be looming ahead.
• Paying creditors late: Consistent calls from angry creditors about overdue bills usually indicate that money is tight. Defaulting on loans and other bills may also lead to lawsuits, requiring expensive legal services that can themselves be a financial setback.
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How Does Insolvency Work?
Taking out small business loans is part of doing business and allows business owners to expedite growth. If a company takes on too much debt too quickly, however, it can lead to insolvency — a state in which it can no longer pay off its debts. If an insolvent company is not able to work out a way to repay the debts, it may face involuntary insolvency proceedings, in which legal action is taken against the business and its assets may be liquidated to pay off outstanding debts.
There are numerous factors that can contribute to insolvency. These include:
1. Lawsuits: Any business involved in a lawsuit (or multiple lawsuits) may be forced to spend large amounts of money for legal protection, and, if it loses, suffer financial penalties.
2. Increased production expenses: If a manufacturer increases its costs or it suddenly costs more to procure goods, these costs are directly passed down to the business. The business may pass down these costs to its customers, but it runs the risk of losing a percentage of its customer base. If it doesn’t pass down the costs, it is then forced to take a reduced profit margin. Both scenarios can lead to reduced cash flow, which in turn can lead to loan defaults.
3. Inability to pivot and adapt to a changing market: If customers start going to a new company or business for their needs, and the original business doesn’t do anything to attract those customers back, it could lose a significant amount in revenue as a result.
4. Human error: Keeping up with a business’s revenue and expenses can be complicated — especially as a business grows. Business owners or personnel who lack the appropriate accounting experience can suddenly find themselves short on cash to cover their liabilities.
Types of Insolvency
There are two types of insolvency, which actually represent different degrees of insolvency.
Cash Flow Insolvency
Cash flow insolvency happens when a company doesn’t have enough in liquid assets to make its debt payments. It may have enough in total assets to cover its debts, but those assets cannot be easily liquidated (converted to cash).
It’s not a good financial situation to be in, but the company probably has a few options moving forward. For example, a cash flow insolvent company can reach out to their creditors, who may be willing to restructure their debt or delay payments (giving them time to liquidate assets). If this happens, penalties or additional interest may be applied.
Learning how to calculate cash flow may help prevent cash flow insolvency, but many factors can contribute to this type of insolvency.
Balance Sheet Insolvency
Balance sheet insolvency means that a company or individual borrower doesn’t have enough in total assets to cover their total liabilities. When balance sheet insolvency occurs, the likelihood of a company going through bankruptcy at some point in the future is high unless it is able to find an angel investor or other infusion of cash, or significantly restructure its debt by working with its creditors.
Technical Insolvency
Technical insolvency is another name for balance sheet insolvency. In both cases, if the value of a company’s liabilities exceeds the value of its assets, the business is technically insolvent and needs to increase its income, decrease its debt, or both.
What’s the Difference Between Insolvency and Illiquidity?
When defining insolvency vs illiquidity, there are a lot of similarities. Both are terms used to describe a business that is dealing with cash flow problems or operational inefficiencies. However, there are major differences, too.
Illiquidity is when a company does not have enough current assets to meet its current liability obligations. It’s the same as cash flow insolvency; however, illiquidity is not the same as balance sheet insolvency. Balance sheet insolvency means a company’s total liabilities exceed its total assets, and it would not be able to fully repay its debts, even if it liquidated all of its assets. Illiquidity is a short-term problem; insolvency is often a long-term problem.
Insolvency vs Bankruptcy
The line between insolvency vs bankruptcy is also sometimes thin. The two may seem synonymous from a dictionary perspective, but from a legal point of view, they are different. Insolvency means a business is in a state of financial distress. Business bankruptcy, on the other hand, is an actual court order that depicts how an insolvent business will pay off their creditors.
A business that is insolvent has not necessarily filed for bankruptcy. There may be other tactics it can use to pay down its debt. Insolvency can often be reversed by negotiating with creditors or if a large amount of cash or large business payment is coming down the pipeline.
Someone who has filed for business bankruptcy has determined that they have no other options to pay off their debt. The court will then determine if they have any assets that they can sell. Proceeds from the sale are given to creditors, and debts are discharged.
Bankruptcy can have a big effect on a debtor’s financial record, however — particularly their credit scores. Businesses that file for bankruptcy may have difficulty getting approved for many types of business loans during the period that the bankruptcy remains on their credit reports.
Legal Processes Involved in Bankruptcy vs Insolvency
A business that can’t remedy its insolvency may well have to file for bankruptcy. Individuals and businesses are eligible to file under Chapter 7 (liquidation of assets) or Chapter 11 (reorganization of debt) of the US Bankruptcy Code. Chapter 13 bankruptcy allows individuals and sole proprietors with regular income to pay their debts over several years.
Among the legal processes involved in Chapter 7 are:
• A means test to ensure that the individual debtor’s income is low enough for Chapter 7
• Administration by a trustee, who takes the remaining assets and turns most of them into cash (with a few exceptions, such as the debtor’s house and car)
• The distribution of the proceeds to creditors by the trustee
• The issuance of a discharge that releases the debtor from its debts
For Chapter 11, there are more steps, such as:
• The debtor files a plan of reorganization for the first 120 days after it files the case.
• A disclosure statement goes out to creditors with enough information that they can evaluate the plan.
• A court ruling confirms or disapproves the reorganization plan.
• Under the confirmed plan the debtor repays some of its obligations and discharges others.
Being insolvent does not in itself require any legal processes. As noted above, insolvency is simply a financial situation in which a business’s assets won’t cover its liabilities.
Recovering From Insolvency
The best tactics for recovering from insolvency will depend on the type of company, as well as the reason behind the insolvency. However, moving from insolvency to solvency typically entails dealing with your debt, improving your cash flow, and strengthening your cash management.
Often, a good first step is to list all of your company’s debts in order of priority, then focus on debts that need to be paid immediately (such as those that could interrupt operations or lead to legal trouble if not paid on time). At the same time, you may want to reach out to your creditors to see if you can negotiate better repayment terms.
Another option to look into is refinancing your debt, which involves comparing small business loan rates and then combining several different loans into one, more affordable, payment.
In addition to managing debt, insolvent companies also typically need to decrease spending.
You may be able to do this by cutting out all unnecessary costs and/or finding cheaper suppliers for materials, stocks, and/or insurance.
Negotiating with Creditors
You may be able to avoid garnishment, bank levies, foreclosure, and bankruptcy by negotiation with your creditors.
Some recommended negotiation guidelines and strategies are:
• Consider filing for bankruptcy. This could also be a negotiation tactic, as your creditors know bankruptcy could leave them empty-handed.
• Aim to settle unsecured debts for 50% or less.
• Have money at hand to make payments promptly.
• Be aware of the big picture and clear about your goals.
Your negotiation strategy may change based on the type of debt. Making changes to unsecured credit card debt, for example, can be tough. But revamping a secured loan from a mortgage lender might be easier.
Financial Restructuring Options
Financial restructuring to address insolvency may include debt restructuring, equity financing, and debt-for-equity swaps. Often, the retrenching process involves asset sales to generate cash and settle debts.
The Takeaway
Insolvency is a term for when an individual or company can no longer meet their financial obligations to lenders as debts become due. There are two types of insolvency — cash flow insolvency and balance sheet insolvency. Of the two, balance sheet insolvency is the one most likely to lead to bankruptcy.
Becoming insolvent can happen for a variety of reasons, including poor business management and financial situations that are beyond a company’s control. Moving your company from insolvency to solvency may involve reaching out to lenders and creditors and restructuring your debt to make payments more manageable.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
What happens when you declare insolvency?
If the creditor is willing, you may be able to restructure your company’s debts so that you are able to pay them off. If they are not, you could potentially face insolvency proceedings, in which legal action is taken against your business and assets may need to be liquidated to pay off outstanding debts.
Is insolvency the same as liquidation?
Insolvency can lead to liquidation, but they are not the same thing. Insolvency is a state of financial distress in which a company is unable to pay its debts as they come due. Liquidation is the process of selling off a business’s assets and distributing any funds to creditors.
When is a business considered insolvent?
A business is considered insolvent when it is unable to pay off its debts with its assets. Cash flow insolvency is when a company doesn’t have enough liquid assets (cash or assets that can quickly be turned into cash) to pay its current debts. Balance sheet insolvency — sometimes referred to as technical insolvency — is when a company doesn’t have enough total assets (liquid or illiquid) to cover its debts.
Can a company recover after becoming insolvent?
Becoming insolvent need not be the end of a company. It may be able to pay down its debt and avoid bankruptcy. For example, negotiating with creditors or restructuring debt obligations may help a company emerge from insolvency.
How long does an insolvency process take?
The time it takes to recover from insolvency varies. It typically depends on the complexity of the business and its chosen turnaround plan. An insolvency attorney or administrator can help with the process. Some steps, such as securing alternative financing, may take only days or weeks. Identifying and fixing expensive inefficiencies, refinancing or restructuring loans, or negotiating with creditors could take months.
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