What Is Insolvency?

Simply put, insolvency is the inability of a debtor to pay back money they owe.

Insolvency is the legal term for the state in which a company or individual is unable to service their debts in the immediate future. It may be that the combined worth of the insolvent party is more than sufficient to deal with the situation, but they simply can’t do it at the given time. This is reflected in the two broad forms of insolvency that are commonly recognised. They have slightly differing definitions: cash-flow insolvency and balance-sheet insolvency.

Cash-flow Insolvency

This is a slightly less serious form of insolvency, as it can usually be resolved through negotiation with creditors. Cash-flow insolvency is about liquid cash reserves falling short of requirements. A crisis of liquidity. The uncomfortable position from which you’re unable to stump up the cash to pay your outstanding bills at the end of the month, but with the knowledge that your assets are worth more than your debts. In other words you have sufficient valuable property that could be liquidated to pay your bills if necessary.

This is the type of insolvency that leaves you unable to pay your electricity bill, but you still own your house and car outright. If you were to sell those assets you’d have more than enough to pay off the outstanding debt, but it seems a little drastic as a response to a bad month’s business. This is where arrangements with creditors become possible, as those who are owed money know that it can be paid back ultimately, so they may be more prepared to wait.

Balance-sheet Insolvency

More difficult to deal with is balance-sheet insolvency. This is sometimes called technical insolvency, and occurs when a company or individual has insufficient assets to cover their debts. In other words, the balance sheet has a greater value in the liability column than it does under assets. So the insolvent business or individual has no means of raising sufficient money to cover all their debts. This is the position that can so often herald bankruptcy.

The paradox of balance-sheet insolvency for businesses is that, unlike the cash-flow variety, the company may have sufficient liquid funds to pay its next bill. The problem is that by law it would not be allowed to do so unless paying that bill would directly benefit all of its creditors. In other words paying a workforce to harvest a crop that could then be sold off as an asset is better value for the creditors than allowing the crop to rot in the fields. Paying to turn raw materials into a finished product would not be allowed, as the finished product may not sell, but the raw materials could command value as an asset in their own right.

In such a situation, bankruptcy or business rescue and restructuring are the most likely future courses. In the case of an individual, an Individual Voluntary Agreement or IVA might be the best course of action.

To find out more about insolvency or for advice if you’re having financial difficulties, contact Irwin Insolvency for impartial and understanding advice.