Legal Terms Explained: What Does Insolvency Mean?
In general, insolvency is the inability to pay debts. However, when we try to go deep inside the concept it is more than that. Very often, the terms “insolvency” and bankruptcy are confused or taken as synonyms.
Both insolvency and bankruptcy deal with such liabilities which exceed the appropriated assets. Insolvency refers to financial state while bankruptcy to a distinct legal concept, i.e. a matter of law. Actually, insolvency may lead to bankruptcy but it is not necessarily like that. However, all bankrupt debtors are insolvent.
“An incapacity to pay debts upon the date when they become due in the ordinary course of business; the condition of an individual whose property and assets are inadequate to discharge the person’s debts“
When we look from the legal point of view, it is a situation when the liabilities of a company or person exceed the assets. But from the practical point of view insolvency is a situation when the entity whether legal or physical, can not raise enough cash to meet obligations or to pay debts.
There are two forms of insolvency: cash-flow insolvency and balance-sheet insolvency. The first one refers to situations when a person or company has enough assets to pay but does not have an appropriate form of payment. Let us look through an example. A person owns a large house and a valuable car. He/she does not have enough liquid assets to pay debts. Negotiation is the best way to resolve the case of cash-flow insolvency. The result of the negotiation may lead the bill collector to wait until the car (or the property one owns) is sold. However, the debtor promises to pay penalties in addition.
What refers to the second form, this is a case when a person or company does not have the necessary amount of assets to pay the debts. In such situations, the debtor may be announced bankrupt (not necessarily).
As soon as the person or legal entity becomes insolvent, the corresponding action must be taken to avoid bankruptcy through generating cash, minimizing overhead costs, decreasing living expenses, renegotiating current debts and/or debt repayments.
So, what is bankruptcy?
In contrast to insolvency, bankruptcy is a legal procedure, when:
- A legal entity or a person submits an application to the court to announce themselves bankrupt.
- A creditor of a legal entity or a person submits an application to declare a legal entity or a person bankrupt
- A legal entity files a special resolution with the Registrar of Companies to be declared as bankrupt.
The following may lead to insolvency:
- A company hires an inadequate accounting or HR (human resources) manager. For instance when the accounting manager improperly creates or follows the budget of the company it may lead to overspending, thus insolvency.
- Rising vendor costs, i.e. when the company pays increased prices for goods and services necessary for them, it automatically increases the cost to the consumer. The business owners prefer to move their company elsewhere to pay less for a product or service instead of paying the increased cost. In this way, they lose clients, consequently the income to pay the creditors of the company.
- Lawsuits from customers or business associates. If the company caused damages to the mentioned entities, it may end up paying a large amount of money as a result being unable to continue operations. Moreover, the income also ceases as the operations do. So, lack of income=unpaid bills leading to insolvency.
- Supply and demand do not overlap. The needs of consumers change rapidly with time. This especially happens when the company does not adapt to the marketplace. Thus, expenses exceed income resulting unpaid bills.
Hiring an attorney
In the case of corporate insolvency, you may hire an attorney to advise you on all legal issues which arise. The issues to discuss may be as following and beyond:
- Appointment of an Insolvency Practitioner
- Recovery realization of assets including sales of business and asset
- The validity of the lender security (if needed) etc.
Surely, this is not the whole material you need to get a complete understanding of the term, nevertheless, this is to provide you with core understanding. There are some more additional options to study. If you find it difficult on your own, get your lawyer to help you with your specific situation. Maybe you will manage to save the company from insolvency?