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What is 'Insolvency'

Insolvency is 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 things 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.

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