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What Is Insolvency and How Does It Work?

What Is Insolvency and How Does It Work?
Lauren Ward
Lauren WardUpdated July 18, 2022
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Business insolvency occurs when a company is unable to settle its debt payments to lenders as they become due because of a lack of assets. This can happen any number of ways, and may be the first step towards bankruptcy for a business.Below, we talk about what you need to know about insolvency, steps you can take to bring your small business out of insolvency, as well as how it compares to illiquidity and bankruptcy.   

What Is Insolvency?

If you’ve never fully understood the meaning of insolvency, it’s defined as a state of financial distress in which an individual or company cannot repay the debts they owe to lenders or creditors. For example, a business may become insolvent if it's unable to keep up with monthly payments due on their business loans or money owed to vendors for goods and services they have already received. Being insolvent often leads to bankruptcy, but insolvency by itself is not the same thing as bankruptcy. Before an insolvent company gets involved in any legal proceedings, they will likely be involved in informal negotiations with creditors, such as setting up alternative payment arrangements. Recommended: What Happens if You Fail to Repay a Business Loan? 

How Does Insolvency Work?

Taking out small business loans is part of doing business and allows business owners to expedite growth. If a company takes on too much debt too quickly, however, it can lead to insolvency – a state in which it can no longer pay off its debts. If an insolvent company is not able to work out a way to repay the debts, it may face insolvency proceedings, in which legal action is taken against the business and its assets may be liquidated to pay off outstanding debts. There are numerous factors that can contribute to insolvency. These include:
  1. Lawsuits Any business involved in a lawsuit (or multiple lawsuits) may be forced to spend large amounts of money for legal protection, and, if it loses, suffer financial penalties. 
  2. Increased production expenses If a manufacturer increases its costs, or it suddenly costs more to procure goods, these costs are directly passed down to the business. The business may pass down these costs to its customers, but it runs the risk of losing a percentage of its customer base. If it doesn’t pass down the costs, it is then forced to take a reduced profit margin. Both scenarios can lead to reduced cash flow, which in turn can lead to loan defaults.
  3. Inability to pivot and adapt to a changing market If customers start going to a new company or business for their needs, and the original business doesn’t do anything to attract those customers back, they could lose a significant amount in revenue as a result. 
  4. Human error Keeping up with a business’s revenue and expenses can be complicated — especially as a business grows. Business owners or personnel who lack the appropriate accounting experience can suddenly find themselves short on cash to cover their liabilities. 
Recommended: Solvency vs Insolvency: Defined and Explained 

Types of Insolvency

There are two types of insolvency, which actually represent different degrees of insolvency. 

Cash-Flow Insolvency

Cash-flow insolvency happens when a company doesn’t have enough in liquid assets to make its debt payments. It may have enough in total assets to cover its debts, but those assets cannot be easily liquidated (converted to cash). It’s not a good financial situation to be in, but the company probably has a few options moving forward. For example, a cash-flow insolvent company can reach out to their creditors, who may be willing to restructure their debt or delay payments (giving them time to liquidate assets). If this happens, penalties or additional interest may be applied.  Learning how to calculate cash flow may help prevent cash-flow insolvency, but many factors can contribute to this type of insolvency. 

Balance-Sheet Insolvency

Balance-sheet insolvency occurs when a company or individual borrower doesn’t have enough in total assets to cover their total liabilities. When balance-sheet insolvency occurs, the likelihood of a company going through bankruptcy at some point in the future is high unless it is able to find an angel investor or other infusion of cash, or it can significantly restructure its debt by working with its creditors. 

What’s the difference between insolvency and illiquidity?

When comparing insolvency vs illiquidity, there are a lot of similarities. Both are terms used to describe a business that is dealing with cash flow problems or operational inefficiencies. But they are not exactly the same. Illiquidity is when a company does not have enough current assets to meet its current liability obligations. It’s the same as cash-flow Insolvency. However, illiquidity is not the same as balance-sheet insolvency, which is when a company’s total liabilities exceed their total assets, and it would not be able to fully repay its debts, even if it liquidated all of its assets. Illiquidity is a short-term problem; insolvency is often a long-term problem.  

Insolvency vs Bankruptcy

The line between insolvency vs bankruptcy is also sometimes thin. The two may seem synonymous from a dictionary perspective, but from a legal point of view, they are different. Insolvency is a state of financial distress. Business bankruptcy, on the other hand, is an actual court order that depicts how an insolvent business will pay off their creditors.A business that is insolvent has not necessarily filed for bankruptcy. There may be other tactics they can use to pay down their debt. Insolvency can often be reversed by negotiating with creditors or if a large amount of cash or large business payment is coming down the pipeline. Someone who has filed for bankruptcy has determined that they have no other options to pay off their debt. The court will then determine if they have any assets that they can sell. Proceeds from the sale are given to creditors, and debts are discharged.Bankruptcy can have a big effect on a debtor's financial record, however, particularly their credit scores. Businesses that file for bankruptcy may have difficulty getting approved for many types of business loans during the period that the bankruptcy remains on their credit reports.

Recovering From Insolvency

The best tactics for recovering from insolvency will depend on the type of company, as well as the reason behind the insolvency. However, moving from insolvency to solvency typically entails managing your debt and improving your cash flow. Often, a good first step is to list all of your company’s debts in order of priority, then focusing on debts that need to be paid immediately (such as those that could interrupt operations or lead to legal trouble if not paid on time) first. At the same time, you may want to reach out to your creditors to see if you can negotiate better repayment terms. Another option to look into is refinancing your debt, which involves comparing small business loan rates and then combining several different loans into one, more affordable, one. In addition to managing debt, insolvent companies also typically need to decrease spending. You may be able to do this by cutting out all unnecessary costs and/or finding cheaper suppliers for materials, stocks, and/or insurance. 

The Takeaway

Insolvency is a term for when an individual or company can no longer meet their financial obligations to lenders as debts become due. There are two types of insolvency – cash-flow insolvency and balance sheet insolvency. Of the two, balance-sheet insolvency is the one most likely to lead to bankruptcy. Becoming insolvent can happen for a variety of reasons, including poor business management and financial situations that are beyond a company’s control. Moving your company from insolvency to solvency may involve reaching out to lenders and creditors and restructuring your debt to make payments more manageable.

3 Small Business Loan Tips

  1. Online lenders generally offer fast application reviews and quick access to cash. Conveniently, you can compare small business loans by filling out one application on Lantern by SoFi.
  2. If you are launching a new business or your business is young, lenders will consider your personal credit score. Eventually, though, you’ll want to establish your business credit.
  3. If you need to borrow money to cover seasonal cash flow fluctuations, a business line of credit, rather than a term loan, provides the flexibility you likely need.

Frequently Asked Questions

What happens when you declare insolvency?
Is insolvency the same as liquidation?
When is a business considered insolvent?
Photo credit: iStock/fotostorm

About the Author

Lauren Ward

Lauren Ward

Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
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