Many people don’t really understand the difference between insolvency and bankruptcy. If you learn that a business or individual that owes you money is insolvent, you may be unsure of what that means for your ability to collect on that debt.

Under U.S. bankruptcy law, insolvency is a “financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at fair valuation.” A debtor may announce that they’re insolvent or a court may issue an insolvency order. There are typically two types: cash-flow and balance-sheet insolvency.

Does insolvency always lead to bankruptcy? 

When a business or individual files for bankruptcy, they have already become insolvent.  However, insolvent parties don’t always go on to file for bankruptcy. 

A look at the two types of insolvency

Cash-flow insolvency, as the name denotes, is a problem with not having enough cash flow to pay debts. Generally, debtors have exhausted all options for obtaining cash before insolvency. It’s also known as equitable insolvency. 

Balance-sheet insolvency is when a company’s or individual’s debts exceed assets. They may be able to liquidate enough assets to pay immediate debts, so this type of solvency can take some time to affect individual creditors. At some point, though, unless the debtor turns their situation around, they will end up with a cash-flow insolvency if they don’t file for bankruptcy first.  

As a creditor, it’s wise to keep an eye on a debtor who is consistently late with payments and/or doesn’t pay in full. You don’t want to be left with considerable outstanding debt if they don’t turn things around. Having legal guidance can help you protect your own business and your own business.