Insolvency

Financial Dictionary -> Debt -> Insolvency

Insolvency sounds like a scary word to many people, ringing bells of bankruptcy and creditors filing bankruptcy petitions against the poor borrower. However, the term insolvency refers to something different. Read on about what insolvency is and how it can be dealt with.

To begin with, let us first draw a distinction between personal and business insolvency. The first one is a financial state in which an individual is no longer able to execute monthly payments to his or her lenders. Business insolvency refers to business enterprises that have turned unable to pay their debts to the crediting institutions. Recent statistical information shows that as much as twenty percent of all newly-opened businesses around the world become insolvent during the first two years of operation, owing mostly to unsteady cash flows. There is also a difference between cash flow and balance sheet insolvency. The first term refers to failure to pay instalments at due dates while the second signals that a company has negative net assets, e.g. its assets are less than the liabilities.

From another perspective, the term insolvency is mostly used to describe the financial troubles of business enterprises, while those of individuals are described with the term bankruptcy. To my mind, however, as a condition, insolvency precedes bankruptcy, because an individual starts mulling over filing a bankruptcy statement only after he or she has found him or herself insolvent. As far as business enterprises are concerned, insolvency sets in when the company's revenues from sales are not enough to cover its production costs. And while a company's expenses are more or less regular, occurring on monthly or weekly basis, revenues could often be quite fitful, especially in times of global financial crisis and unstable markets.

And once revenues become fitful, the company invariably starts delaying the payments to its creditors and, voila, the entity has become insolvent. It is as simple as that. Here it should be noted that a company may become insolvent even if it has registered some profit over a period of time, if that profit is not enough to cover the sums it owes to its creditors.

In some milder cases of insolvency, the company's management may deal with the situation on its own, by negotiating a grace period with the creditors and employing some strategies to secure a steady cash flow. These strategies might involve developing a new marketing strategy, launching a new product or a series of products and, last but not least, carrying out an optimization of their workforce as part of the overall belt-tightening plan.

In general, the focus of insolvency rests on remodelling the organizational and financial structure of debtors as to allow the continuation of their business operations. This process is known as Business Recovery and Business Turnaround. In the United States, insolvent businesses may continue functioning while under a declared protective arrangement and until alternative recovery strategies are worked out. However, paying to some creditors and not to others may be grounds for an offence or civil action if a state of insolvency has been reached.

If the creditors have initiated legal action against the insolvent company over the payments due, then the business may be forced to go into liquidation, and its assets, including means of production, plots of land, and real properties, could be auctioned so as to raise funds against the company's debts.