Insolvency is the financial state in which a person or company can no longer pay its bills and other monetary obligations in a timely manner. According to the Internal Revenue Service (IRS), a person is insolvent when his or her total debts add up to more than the fair market value of his or her total assets — homes, land, vehicles, bank accounts, and stocks and bonds.
Business insolvency falls into two categories:
- Cash flow insolvency occurs when a company is unable to pay its debts when they are due.
- Balance sheet insolvency occurs when a company has negative net assets (total debt surpasses total assets).
A business can be cash flow insolvent, but balance sheet solvent, if it holds non-liquid (non-cash) assets worth more than its liabilities. The reverse is also possible: A business can be balance sheet insolvent (more debt than assets), but cash flow solvent if its revenues allow it to meet its immediate financial obligations. Many companies that hold long-term debt operate continually in this state.
Insolvency vs. Bankruptcy
Insolvency is not the same as bankruptcy. Insolvency is a state of economic distress, whereas bankruptcy is a court order that defines how an insolvent debtor will meet his or her obligations and/or have assets liquidated (sold) to pay the creditors.
So an individual or company can be insolvent without being bankrupt — especially if the insolvency is temporary and correctable — but not the opposite. However, insolvency can lead to bankruptcy if the insolvent party is unable to successfully address its financial condition.
Insolvent companies can reverse course by cutting costs, selling off assets, borrowing money, renegotiating debt, or allowing themselves to be acquired by a larger corporation that will agree to take over the insolvent company’s debts in return for control of its products or services.
A court can deem a company or individual insolvent by issuing an insolvency order. A debtor can petition for an insolvency order as part of a request for personal bankruptcy protection. In most jurisdictions, an insolvency order temporarily prevents any attempts at debt collection. Conversely, a creditor can, in some instances, request an insolvency order to be issued against a debtor, if there is reason to believe that the debtor can repay all or part of the debt. In that case, the court can issue an insolvency order, requiring the debtor to repay a portion or all of the debt.