What is Insolvency?

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Definition:

Insolvency occurs when a legal entity has more debts than assets or can’t pay off debts on time.

🤔 Understanding insolvency

Insolvency occurs when you can’t pay your bills. Specifically, it happens when a person or entity has more debts than assets or can’t repay their creditors (those they owe money to) on time. Insolvency can result from not having enough cash flow (money going in and out of a business), having too many expenses, or mismanagement, among other situations. Insolvency is often confused with bankruptcy, but they are not the same. Insolvency is a state in which you can’t pay your debts, while bankruptcy is a legal proceeding that determines how creditors will be paid. You can be insolvent without being bankrupt, but not vice versa.

Example

Imagine a business called Maybelline’s Marbles typically brings in $10,000 in revenue and pays $9,000 in expenses — mostly debt payments — every month. Clearly, Maybelline is operating her business on very thin margins. One day, a competitor, Martin’s Marbles, emerges. Half of Maybelline’s customers switch to Martin, and her revenue drops to $5,000 per month. Over the next few months, Maybelline can’t pay her debts and expenses — Her company becomes insolvent.

Takeaway

Insolvency is kind of like sinking in a ship . . .

When you first notice a leak in your ship, you’re able to plug it up easily. But soon another leak pops up, and then another, and another, until you can’t fill all the holes fast enough. The situation quickly becomes unmanageable, and your ship starts sinking. Similarly, when a business becomes insolvent, debts keep piling up until a person or organization can’t pay them off anymore. At that point, they may choose to file for bankruptcy.

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What is insolvency?

Insolvency is a state of financial distress in which a business, individual, or other legal entity either has more debts than assets or can’t pay back its creditors (those it owes money to). In short, it’s when you can’t afford to pay your bills.

There are many reasons organizations or individuals could be winding up insolvent, such as poor financial management, insufficient cash flow (the money coming into and going out of a business), or too many expenses. Or the culprit can be an unexpected event, such as the COVID-19 pandemic, which slashes revenue and income across regions and industries.

Insolvency typically comes in two forms:

  • Balance sheet insolvency (aka technical insolvency) occurs when an individual’s or a company’s assets (items of value they own) are worth less than their liabilities (debts). While they may be able to cover their debts for a while, the situation can become unsustainable, especially if expenses increase in the future.
  • In cash flow insolvency, a business or individual can’t pay their debts as they become due. Insolvency typically spells the end for a business in its current form, unless it can restructure its debts or find another way to pay them off. Insolvent individuals and companies may consider filing for bankruptcy as a last resort.

What factors contribute to insolvency?

Individuals and businesses can both become insolvent, often for different reasons.

Individuals often become insolvent due to:

  • Divorce: When a married couple splits, debts may be divided unevenly. If one spouse relied on the other for debt payments, he or she may struggle to do so alone. Hefty legal fees can also come into play.
  • Losing a job or getting a pay cut: When someone gets laid off or receives a pay cut, they may have trouble keeping up with debt payments. Unless they find a new job or get a raise quickly, insolvency can easily follow.
  • Medical bills: People who have sudden health issues (especially those without health insurance) may incur substantial medical expenses that they can’t pay off.
  • Imprudent use of credit: People who aren’t careful with credit card spending can accrue a balance that’s too high to pay off. Add compound interest into the equation, and credit card debt can quickly become unmanageable and lead to insolvency.

Most insolvent companies struggle financially due to microeconomic or macroeconomic factors, or both.

Microeconomic factors relate to specific industries and business behavior, such as:

  • Inadequate accounting practices
  • Poor business strategy and leadership
  • Lack of innovation
  • Increased production or supply chain costs
  • Strong competitors
  • Lawsuits

Macroeconomic factors consider circumstances on a broader level outside of a firm or industry, such as:

What are the warning signs of insolvency?

Some common warning signs of insolvency include:

  • Missed payments: Although it’s common to miss a payment here and there, constantly failing to pay on time could indicate that a firm or individual can’t repay their debts.
  • Reduced margins: As a company’s profit margins get thinner, it becomes increasingly likely that it won’t be able to continue paying its debts. The same holds true for an individual — If you’re consistently spending close to or more than you bring in every month, you could be headed for insolvency.
  • Negative language in management statements: Researchers at Duke University found that negative language in corporate statements, such as “challenging,” “unforeseen,” and “renegotiate,” can be predictors of financial distress.
  • Low morale: A company in financial distress often institutes layoffs or freezes raises and promotions. This can result in overworked staff, departures of senior staff, and generally low morale.

What is the difference between insolvency and bankruptcy?

Insolvency is a state of financial distress in which a person or company either can’t pay debts on time or has total assets worth less than total liabilities. Bankruptcy, on the other hand, is a legal proceeding in which debtors seek relief from their liabilities. In a bankruptcy proceeding, a court decides how a company’s outstanding debt will be handled.

You can be insolvent but not file for bankruptcy. However, you can’t file for bankruptcy without first proving insolvency.

Who can declare insolvency?

Insolvency cannot be declared in the US. However, insolvent firms and individuals can declare bankruptcy, which involves going through a legal process to tackle outstanding debts. The most common types of bankruptcy in the US are:

Chapter 7 bankruptcy, which allows a company or individual to liquidate certain assets in order to pay their debts.

Chapter 11 bankruptcy, which mainly companies use to restructure their debts and work out a repayment plan.

Generally, in order to be able file for Chapter 7 or Chapter 11 bankruptcy :

You can’t have had a prior Chapter 7 bankruptcy in the last eight years or Chapter 13 bankruptcy in the last six years.

You can’t have had a bankruptcy case dismissed in the last 180 days because:

  • You missed a court appearance on purpose.
  • You had a bankruptcy case dismissed by the court for fraud or abuse of the bankruptcy system.
  • You dismissed a bankruptcy case after creditors tried to recover property for which they held liens.

How do you file for insolvency?

It is impossible to file for insolvency. However, insolvent businesses and individuals can file for bankruptcy, which is a legal recognition of their insolvent state.

How to file for bankruptcy can differ depending on whether you are filing for Chapter 7 or Chapter 11 and whether you’re a business or individual. Generally you can expect something like the following:

  1. Individuals must receive credit counseling from an approved agency within 180 days before filing for both Chapter 7 and Chapter 11.
  2. Individuals and firms must file a formal petition with the local bankruptcy court.
  3. Individuals and firms must file a schedule of:
  • Assets and liabilities
  • Income and expenditures
  • Executory contracts and unexpired leases
  • Statement detailing your current financial situation
  • Tax returns (Chapter 7 only)
  • A schedule of exempt property (Chapter 7 only)
    1. If you are filing as an individual, you must also file:
  • A certificate from the credit counseling and a copy of the debt repayment plan
  • A statement of monthly net income (if any)
  • Any records of interest for education or tuition loans
    1. Applicants must pay a filing fee which can range from several hundred dollars for Chapter 7 to over $1,000 for Chapter 11.
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