What is Insolvency?

Published by Thomas Herold in Accounting, Corporate Finance, Economics, Laws & Regulations

'Insolvency' is explained in detail and with examples in the Economics edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

Insolvency refers to the point where an individual, business, or even governmental organization is not able to cover its various financial obligations any longer. This means that it is unable to settle debts with its creditors and lenders as they are due. Many times, before such an indebted individual, company, or government becomes embroiled in any type of insolvency or bankruptcy procedures, they will try to enter into informal negotiations with creditors. This could involve setting up other payment schedules and arrangements.

Insolvency can happen for a variety of reasons. Among these is a decrease in cash flow and profitability forecasts, poor management of cash resources, or a rapid expansion in costs and expenses. Where businesses are concerned, this type of insolvency is classified according to one of two separate categories. The first of these is Cash Flow insolvency. This happens as a corporation or company simply can not pay the business debts as they become due. The second form is Balance Sheet insolvency. This type results from a company reaching the point where it possesses a negative net asset position. It simply means that the corporation’s aggregate debts are greater than its total assets.

It is entirely possible for firms to be solvent by balance sheet figures but at the same time be insolvent by cash flow. The opposite scenario could also occur. If a company is bankrupt according to its balance sheet while still solvent by cash flow, it simply means its incoming revenues permit it to cover its current financial obligations. There are numerous companies which possess longer term debt obligations that continuously operate in this balance sheet-bankrupt status.

Technically, insolvency and bankruptcy are not exactly the same thing. The former is a condition of being in financial trouble or at least difficulties. Bankruptcy is instead a court order. It describes the ways in which a debtor which is no longer solvent will continue to meet its obligations or instead have its assets sold off to settle with the creditors.

This means that it is entirely possible for a company, individual, or government entity to be no longer solvent but not yet be officially bankrupt. This could result from a temporary or sometimes fixable problem. The reverse is never the case. An entity can not be bankrupt yet still be solvent. Such a lack of solvency often translates into an eventual bankrupt state when the debtors are not able to improve their financial conditions.

Corporations and firms that have become insolvent are able to improve their financial state. They might slash costs, borrow money, sell their assets, renegotiate the terms of their debts, or seek out a bigger corporation to acquire them. The buyer could settle their debts as part of the assumption of their services, products, technology, and proprietary trademarks.

Several unfortunate events can lead to a company becoming insolvent. If they do not have enough management in human resources or accounting departments, this could contribute to the problem. A lack of qualified accounting staff could cause a company’s budget to be either ignored or misappropriated.

There might also be sharply increasing vendor prices which the company is powerless to stop. Higher prices for their goods and services mean that companies will have to raise their prices in an effort to pass these along to the consumer. The problem arises when customers then shop another company or product to get a better price. Lost clientele nearly always translates into a drop in cash flow. This means that they no longer have the cash coming in to cover the bills due to the company creditors.

There could also be lawsuits brought by employees or customers that break a company’s finances. The firm could be forced to pay enormous bills for both defense and in settlement damages which make it impossible for them to continue ongoing operations. As operations cease and revenue naturally drops, the ability to pay bills disappears quickly.

A final reason centers on the lack of evolution in a company product line. It might be customers simply change their needs and therefore purchasing habits. This could lead them to rival firms which offer a broader product range or line. The company which could not or did not adapt its products will find its revenues and profits decreasing to the point where they are unable to cover their expenses with their remaining income.

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The term 'Insolvency' is included in the Economics edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.