You can be insolvent without being bankrupt, but you can’t be bankrupt without being insolvent.
Confused yet? Many people think of the two as the same thing, but they are very different. Insolvency is a problem that bankruptcy is designed to solve.
Insolvency is the inability to pay debts when they are due. Fortunately, there are solutions for resolving insolvency, including borrowing money or increasing income so that you can pay off debt. You also could negotiate a debt payment or settlement plan with creditors.
Bankruptcy is usually a final alternative when other attempts to clear debt fail.
To make things a little more complicated, insolvency comes in two flavors. The first, called “cash-flow insolvency,” occurs when an insolvent debtor can’t make a payment because he doesn’t have the money. The second, called “balance-sheet insolvency,” results when debts exceed assets.
In the first case, the debtor doesn’t have the money to make a payment when it’s due; in the second it might be possible to make a payment with cash on hand, but financial collapse might not be far off. Paying debts will deplete cash and that leads to cash-flow insolvency.
Insolvency only becomes an issue when a creditor seeks to collect and the debtor can’t pay what’s due. Failing to pay debts usually leads to debt collection efforts that force some kind of action. For example, if you own a house and don’t pay the mortgage, you’ll go into default that can soon lead to foreclosure. If you can’t meet minimum monthly payments on your credit cards and you don’t try to work out a solution with the card company, you’ll almost certainly hear from debt collectors.
Think of insolvency as the trigger for financial hardship. If you can’t pay your rent or electric bill because you don’t have the money, you could call faithful Aunt Beth and ask for a loan. If you get one, the insolvency goes away, probably temporarily unless you are able to balance your income and expenses. The longer you are insolvent, the worse things will become.
If you can’t resolve the insolvency, bankruptcy might be the only way to stop your financial hemorrhaging. Showing that you’re insolvent is necessary for establishing a bankruptcy claim. Federal bankruptcy law defines insolvency for corporations and individuals as the “financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at fair valuation.”
In other words, you owe so much that selling all your assets won’t cover the bill.
Cash Flow Insolvency
When you can’t pay a debt because you don’t have the money, you are cash-flow insolvent. If insolvency were a medical problem, doctors might call it an acute condition. Many people see financial trouble in their future, what might be called a chronic problem, but they aren’t cash-flow insolvent until they can no longer pay their bills. Financial trouble is chronic; not paying you bills is acute, since that’s the moment when a problem becomes a personal crisis.
Cash flow, or equitable, insolvency impacts both businesses and individuals. Usually it occurs when they’ve exhausted other ways of resolving debt. If you have a credit card payment due, you might be able to liquidate an asset like a lawnmower to pay a debt and avoid cash-flow insolvency, at least for the moment. When you run out of assets to sell and places to borrow money, and your income isn’t enough to cover your debts, you’ll probably be forced to negotiate a payment agreement with your creditors, either directly or through a debt management firm.
Deciding what to do about this type of insolvency requires taking a cash-flow test. The debtor needs to evaluate current and future cash flows to determine whether your income is enough to cover debt payments. If you have an inheritance distribution or some other windfall coming in a few months, your insolvency might be temporary, but if you’ve sold your assets and your income is not going to increase, you might not have a easy way out of insolvency. The analysis can help you decide whether to seek a debt settlement or file for bankruptcy protection.
Balance Sheet Insolvency
Businesses commonly use a balance sheet insolvency test to decide whether to take steps to stay afloat or file bankruptcy. To decide, the business will evaluate its inflows, outflows and assets. If inflows are less than outflows and the value of the business’ assets are worth less than what is owed – a condition called negative net assets — it might conclude that restructuring without the help of a bankruptcy filing might be pointless. But if it has assets that could be sold – a truck or store locations, for instance – that could be used to cover debts, it might attempt to sell the asset and shrink the business.
Financial advisors will review business operations, suggest scenarios for reducing or eliminating debt and suggest a course of action. Staying in business might require that the company convince its creditors that it has made the correct assumptions about future cash flows, but many times businesses and their lenders don’t see eye to eye.
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 decides how an insolvent debtor will deal with unpaid obligations. That usually involves selling assets to pay the creditors and erasing debts that can’t be paid. Bankruptcy can severely damage a debtor’s credit rating and ability to borrow for years.
An individual or company can be insolvent without being bankrupt — especially if the insolvency is temporary and correctable — but not the opposite.
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 assets, borrowing money, renegotiating debt or allowing themselves to be acquired by a larger corporation that agrees to take over the insolvent company’s debts in return for control of its products or services.
What If I’m Insolvent?
If you are financially overwhelmed and sure you can’t pay your debts, you should contact a non-profit debt counsellor or debt management company that can help you review your balance sheet. Even if you don’t have enough income to pay your debts, a debt manager can try to negotiate a settlement that will partially repay what you owe and avoid a bankruptcy filing.
You can also try to negotiate with creditors on your own. If you owe a large credit-card debt, contact the card issuer and explain your situation. Though the debt holder is under no obligation to offer a workout plan, reduce your debt or trim you interest rate, it’s in their best interests to try. So, you might be able to reach an agreement if you can convince the creditor that it’s either an agreement or default.
Remember, if you reach an agreement that involves debt forgiveness, you might be liable to pay taxes on the amount the creditor writes off. However, the Internal Revenue Service allows insolvent and bankrupt taxpayers to reduce cancelled debt by their insolvency amount.
For example, if a creditor agrees to settle a $20,000 debt with a $5,000 payment from you, you would have cancelled debt income of $15,000. But if you only had $3,000 in assets at the time you reached the agreement, you would insolvent in the amount of $12,000 ($15,000 cancelled debt income minus $3,000 assets). You would then report $3,000 in income on your taxes ($15,000 less the $12,000 insolvency amount).
If you are unclear about this, contact a nonprofit credit counseling agency or a tax professional.
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 all or part of the debt.
Reasons for Insolvency
Individuals and businesses can become insolvent for a vast number of reasons, but some of the most common include:
- Job loss or salary reduction
- Medical bills
- Imprudent use of credit
- Financial mismanagement
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Saavedra, A. and Hopkins, C. (2013, October 30) The Statutory Definition of Insolvency. Retrieved from: https://business-finance-restructuring.weil.com/valuation/the-statutory-definition-of-insolvent-part-one/#content