A business can be insolvent without being completely bankrupt. But a business cannot be bankrupt without being insolvent. The difference between insolvency and bankruptcy is fine, but very distinct. In its most basic sense, bankruptcy is a solution for businesses that have become insolvent. So despite what you might have believed, bankruptcy and insolvency are two very different things. This blog explores the difference in detail.
What is Insolvency?
When I was working for a mortgage recruiter, I once interviewed a candidate. She had run her own small mortgage staffing agency before becoming insolvent during the recession from 2007 to 2008. During this time, a large number of firms connected to the real estate, mortgage, and title industry collapsed into bankruptcy.
In it’s most essential form, business insolvency is a state of being that leads to bankruptcy. It refers to a business’s inability to pay its debts on time to its lenders. In most cases, for businesses, this means that the money flowing into the business plus its assets are no longer sufficient to take care of its liabilities. There are several ways to resolve insolvency.
You can negotiate a debt payment plan, restructure your debt, or even get short-term borrowing to pay off your existing liabilities. It is not unheard of for businesses to recover from short-term insolvency. However, if all else fails, the only solution left is bankruptcy. But first, more on the types of business insolvency.
Type #1: Cashflow Insolvency
Cashflow insolvency occurs when a business is unable to pay its debts because it does not have the cash to do so. Financial troubles can be an ongoing feature of running a business. However, being unable to pay your debts on time due to a lack of cash is a serious and immediate concern.
Also known as equitable insolvency, it can seriously hamper business growth and continuity. It is usually the case when a business has exhausted all other means of clearing its debts. That is including short-term borrowing and liquidating certain assets. However, if income remains insufficient, sooner or later a business will run out of assets to sell and sources to borrow money from. This is when you’re forced to restructure your debt or negotiate a debt payment plan with your lenders.
So how do you deal with cash flow insolvency? The first step involves a detailed evaluation of cashflows, both present, and future. This will help you get a better idea of where your business income stands with respect to your ability to pay back your debts on time. If you have any incoming sources of inflows, you may be able to cover your debts soon. And the insolvency will only be temporary. But if you have exhausted all your inflows and income remains insufficient, you may need to look at bankruptcy as a valid option.
Type #2: Balance Sheet Insolvency
In a balance sheet insolvency, the problem does not lie with the cashflows but with the business’s net assets. Balance sheet insolvency refers to a state where a business’s debts exceed the value of its assets. To determine if your business has this type of insolvency, you will need an evaluation. Not just of the cash inflows and outflows, but the business’s assets as well.
When your cash outflows exceed cash inflows, and your assets are diminished in value compared to your liabilities, you might be balance sheet insolvent. In this case, you may not be able to survive even if you restructure your debts, and bankruptcy may be the only real option left. On the other hand, if you still have assets you can liquidate to cover debt payments, you can opt to do so to maintain business continuity while shrinking it to some degree.
Comparing Insolvency and Bankruptcy
There is one very major distinction between bankruptcy and insolvency. Insolvency refers to a business condition. While bankruptcy is an order by a bankruptcy court determining how an insolvent debtor will discharge its liabilities. In most cases, a bankruptcy order will dispose of all of your assets. Then it will use the proceeds to pay off as much of your obligations as possible. The debts that can’t be met are erased.
On the other hand, declaring bankruptcy can have a negative impact on your ability to borrow from a bank, as many of them will be wary of lending to a borrower with a recent bankruptcy. It will also impact your credit rating, which determines, among other things, the interest you are charged for a loan.
Insolvency is a correctable situation and can be reversed, but the same is not true for bankruptcy. There are several avenues available to businesses going through insolvency. The biggest one is cutting costs, such as outsourcing key business functions. For example, instead of maintaining in-house recruiters, you could work with a local engineering staffing agency.
Instead of maintaining on-site servers, you could simply subscribe to a cloud server. You can also look at borrowing more money in the short term, selling off certain assets, and even renegotiating your debt structure. But if you declare bankruptcy, the only solution is the liquidation of all your assets to pay off your debts.
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