Business insolvency is often confused with bankruptcy. While they are two different things, insolvency often precedes bankruptcy. It doesn’t have to, though. Learning more about what insolvency is can help business owners who are trying to restructure their debt without having to file for bankruptcy or close their doors.
Under U.S. bankruptcy law, insolvency is defined as a “financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at fair valuation.” It essentially means a business can’t pay its bills and other debt on time. There are multiple types of insolvency. The most common are balance sheet and cash flow insolvency.
What is balance sheet (accounting) insolvency?
Balance sheet insolvency, which is also known as accounting insolvency, is when a business’s debts are greater than its assets. That makes it difficult, if not impossible, to pay anyone they owe on time. That includes suppliers, employees and others they need to pay to keep the business running.
Sometimes, business owners ask creditors to agree to an arrangement where the owners to pay what they owe in installments they can afford. While that only works if they can see a way out of their insolvency and their creditors have faith that they have a plan to improve their liquidity. Creditors often would rather get paid later than expected than have the business owners file for bankruptcy and risk getting little or nothing.
What is cash-flow (equitable) insolvency?
Cash-flow insolvency is when a business lacks the liquid assets to pay its debts when they’re due. Its total assets exceed its liabilities, unlike with balance sheet insolvency. However, many of those assets are fixed (buildings and equipment) and can’t be used to pay their bills. The owners may be able to liquidate some of those fixed assets without harming the company’s operations to pay the debts. That’s not always possible, however.
Regardless of what kind of insolvency a business owner is facing, it’s wise to get professional guidance sooner rather than later. By learning more about their options for debt relief – including bankruptcy – they can decide on the best path forward for their company.