Insolvency and bankruptcy are often confused for one another, but they are not the same. While both apply to a business struggling to pay its obligations, each has different processes and outcomes.
What is Insolvency?
Insolvency is considered a financial status. It means that a business cannot pay its obligations promptly. Per the Internal Revenue Service (IRS), a business is insolvent when the total debt due is more than the company’s fair market value for any company-owned assets, including company vehicles, materials, property, stocks, bonds, and accounts receivable.
A business insolvency falls into one of two main categories:
- Cash Flow Insolvency – A cash flow insolvency is when your business cannot pay debt obligations when they are due because your company has poor cash flow.
- Balance Sheet Insolvency – If your business has a negative balance sheet or negative assets, then you are in a balance sheet insolvency situation.
You might be cash flow insolvent, but balance sheet solvent – this means that your company has more assets than debt obligations, but you do not have any cash reserves to pay your debt obligations. Conversely, your business could be cash flow solvent, but balance sheet insolvent. This would mean that there is adequate cash flow for immediate obligations, but total liabilities exceed assets – leaving a negative balance sheet.
Understanding the Differences Between Insolvency and Bankruptcy Status
Insolvency means your company is in financial distress, but bankruptcy is a court determination that decides which obligations are paid and how. You could be insolvent without your business being bankrupt. Sometimes, insolvency is a temporary condition, while other times it is easily corrected by liquidating certain business-related assets. Insolvency can, however, lead to bankruptcy if you are unable to meet your debt obligations.
If your business is insolvent, you may still have options, such as selling assets; cutting expenses to preserve reserves; borrowing funds; renegotiating debt obligations; or engaging in an acquisition with a larger, more stable company.
The court may deem your business “insolvent” through an insolvency order. You will need to file this request through a business attorney; doing so could offer you protections against creditors as part of a bankruptcy application. Your creditors may already require an insolvency order if you are dramatically behind on your debts and they believe that you could repay those debts by liquidating certain assets or other means.
If your business is struggling, you may want to explore the options of insolvency orders or bankruptcy. If a creditor is requiring an insolvency to force you into paying off debts, a bankruptcy filing could help you resolve outstanding debt without liquidating your entire business.