A lot of people think that insolvency and bankruptcy are essentially the same thing – or at least that insolvency is a precursor to bankruptcy. That’s why it’s important to understand that they are two different things – and that recognizing and handling insolvency wisely may allow some business owners to avoid bankruptcy and/or shutting their doors.
U.S. bankruptcy law defines insolvency 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.” There are different types of business insolvency. Let’s briefly look at the two most common.
Accounting (balance sheet) insolvency
Accounting insolvency is a condition where a business’s debts exceed its assets. This can be particularly serious because even if a business is able to sell some of its assets, like equipment, and continue to operate, those assets don’t have enough value to pay off the debt.
If a business owner has a viable plan for improvement, they may be able to make arrangements with their creditors to pay what they owe in installments over time or even pay a percentage of what they owe. Many creditors would rather delay getting paid or settle for a portion of it than risk the business filing for bankruptcy and potentially getting nothing.
Equitable (cash flow) insolvency
With cash flow insolvency, a business’s total assets exceed its debts, but that includes their fixed assets as well as their liquid assets. That means to pay off their debts, the business owner would likely need to liquidate some of those fixed assets, like equipment and property. Whether that is feasible depends on what percentage of the assets are fixed and whether they can sell them without damaging or destroying the business.
When a business owner is facing any type of insolvency, it’s wise to get legal and other professional guidance to determine the best way forward for the business and those who depend on it.