What is Business Insolvency?

H. Terry

Business insolvency is when a business cannot afford to pay its debts. There are two kinds of business insolvency: cash flow insolvency and balance sheet insolvency. Business insolvency should not be confused with bankruptcy.

Businessman with a briefcase
Businessman with a briefcase

Whenever a business cannot afford to pay debts to creditors, the situation is called business insolvency, but this situation can vary in terms of severity. Cash flow insolvency is when debts cannot be paid on time because the cash is not readily available. Balance sheet insolvency is when a business' liabilities exceed its assets. In this case, the business is less likely to be able to pay off its long-term as well as its short-term debts.

In cases of insolvency, especially temporary cash insolvency, creditors will normally try to establish alternative payment arrangements with the debtor before taking any legal action. Most commonly, with good will on both sides, an arrangement can be made in this way. If the debtor refuses to enter into communication with the creditor or is unable to agree to a new payment plan, the creditor has the following options: hire an attorney, take legal action independently, refer the case to a cash collection agency or take no action. If taken to court, the insolvent entity may be obliged to liquidate assets in order to pay off debts.

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While frequently misused as synonyms, business insolvency and bankruptcy are quite distinct. Insolvency is a problematic financial situation that might be rectified in various ways. Bankruptcy, on the other hand, is a legal process that is turned to as a way of dealing with insolvency in very difficult cases. Bankruptcy involves selling off all of the insolvent entity's assets and also implies other negative consequences for the person or people involved, such as difficulty securing future credit and the possibility of losing equity. While people can chose to declare bankruptcy independently, it is often the case that creditors are the first to request that it be considered.

Insolvency can occur due to unforeseen expenses, market changes or poor financial management. Depending on the circumstances and the insolvent entity's relationship with its creditors, there is a range of ways by which the entity might be able to pay its debts and avoid bankruptcy. Bankruptcy comes at a very great cost, and as such, it should always be treated as a last resort after all other options have been exhausted.

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