Loading the player...

What is 'Insolvency'

Insolvency is a term for when an individual or organization can no longer meet its financial obligations with its lender or lenders as debts become due. Before an insolvent company or person gets involved in insolvency proceedings, it will likely be involved in informal arrangements with creditors, such as making alternative payment arrangements. Insolvency can arise from poor cash management, a reduction in cash inflow forecasts or from an increase in expenses.

BREAKING DOWN 'Insolvency'

Insolvency is a state of financial distress in which someone is unable to pay their bills. It can lead to insolvency proceedings, in which legal action will be taken against the insolvent entity, and assets may be liquidated to pay off outstanding debts. There are numerous factors that can contribute to a person or company’s insolvency.

Insolvency vs. Bankruptcy

Contrary to what most people believe, insolvency is not the same thing as bankruptcy. Insolvency is a type of financial distress, meaning the financial state in which a person or entity is no longer able to pay the bills or other obligations. The Internal Revenue Service (IRS) states that a person is insolvent when the total liabilities exceed the total assets. But a bankruptcy is an actual court order that shows just how an insolvent person or business will pay off his creditors, or how he will sell his assets in order to make the payments. 

So a person or corporation can be insolvent without being bankrupt, even if it's only a temporary situation. If that does extend longer than anticipated, it can, however, lead to bankruptcy. 

Factors Leading to Insolvency

A company’s hiring of inadequate accounting or human resources management may contribute to insolvency. For example, the accounting manager may improperly create and/or follow the company’s budget, resulting in overspending. Expenses add up quickly when too much money is flowing out and not enough is coming into the business.

Rising vendor costs may contribute to insolvency. When a business has to pay increased prices for goods and services contributing to their offerings, the company passes along the cost to the consumer. Rather than pay the increased cost, many consumers take their business elsewhere so they pay less for a product or service. Losing clients results in losing income for paying the company’s creditors.

Lawsuits from customers or business associates may lead a company to insolvency. The business may end up paying large amounts of money in damages and be unable to continue operations. When operations cease, so does the company’s income. Lack of income results in unpaid bills and creditors requesting money owed to them.

Some companies become insolvent because their offerings do not evolve to fit consumers’ changing needs. When consumers begin doing business with other companies offering larger selections of products and services, the company loses profits if it does not adapt to the marketplace. Expenses exceed income and bills remain unpaid.

Negotiating With Creditors

Business owners may contact creditors directly and restructure debts into more manageable installments. Creditors are typically amenable to this approach because they understand cash flow issues arise with businesses and they want repayment.

Business Debt Restructuring

If a business owner plans on restructuring the company’s debt, he assembles a realistic plan showing how he can reduce company overhead and continue carrying out business operations. The owner creates a proposal detailing how the debt may be restructured using the cost reduction or other plans for support. The proposal shows creditors how the business may produce enough cash flow for profitable operations while paying its debts.

RELATED TERMS
  1. Accounting Insolvency

    Accounting insolvency refers to a situation where the value of ...
  2. Bankruptcy Risk

    Bankruptcy risk refers to the likelihood that a company will ...
  3. Insolvency Clause

    An insolvency clause requires the reinsurer to uphold its obligations ...
  4. Corporate Debt Restructuring

    Corporate debt restructuring is the reorganization of a distressed ...
  5. Chapter 15

    Chapter 15 is a section in the U.S. Bankruptcy Code added to ...
  6. Preferred Creditor

    A preferred creditor is an individual or organization that has ...
Related Articles
  1. Personal Finance

    7 Tips For The Do-It-Yourself Debt Manager

    Hired gun not in your budget? Learn to be your own credit counselor.
  2. Personal Finance

    Debt Settlement: Cheapest Way to Get Out of Debt?

    Debt settlement is not for everyone, but for those seriously in debt it may prove an effective means of solving the problem.
  3. Personal Finance

    Fighting Back Against Collection Lawsuits

    There are still options available to those being pursued by a creditor.
  4. Insights

    The Difference Between Restructuring & Refinancing

    Refinancing and restructuring are very different debt reorganization processes to avoid bankruptcy.
  5. Investing

    The Pros and Cons of Distressed Debt Investing

    Distressed debt investing is suitable for professional investors. Besides heavy risk factors to consider, this investment type can provide a large ROI.
  6. Personal Finance

    What You Need To Know About Bankruptcy

    Don't choose this last-resort option until you learn how it will affect your future.
  7. Financial Advisor

    Corporate bankruptcy: An overview

    When public company files for corporate bankruptcy, the bondholders are first in line to receive their share back. Equity holders on the other hand, are second in line to bondholders when a corporate ...
  8. Personal Finance

    Unemployed? 5 Smart Ways to Get Control of Debt

    When you're unemployed and barely making ends meet, smart debt advice can help you stay on top of your payments and protect your credit rating.
  9. Personal Finance

    6 Ways Advisors Help Clients Manage Consumer Debt

    Here are six practical ways advisors can help clients manage their debt.
  10. Personal Finance

    Should You File for Bankruptcy?

    Find out how to determine whether bankruptcy will help or hurt your financial situation.
RELATED FAQS
  1. Which Creditors Are Paid First in a Liquidation?

    Find out the order in which creditors are paid during a corporate liquidation. Learn how bankruptcy claims by secured and ... Read Answer >>
Hot Definitions
  1. Yield Curve

    A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but ...
  2. Portfolio

    A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, also their mutual, exchange-traded ...
  3. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  4. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  5. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  6. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
Trading Center