Even many business owners don’t fully understand the difference between insolvency and bankruptcy or they assume that insolvency is always followed by bankruptcy. While insolvency may lead to bankruptcy, it doesn’t have to.
The more you understand about the different types of insolvency, the better you can understand where your business is and how you can potentially take effective steps to prevent having to file or bankruptcy or close your business.
U.S. bankruptcy law defines insolvency as a “financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at fair valuation.” That’s a long-winded way of saying a business (or individual) can’t pay their bills – at least not on time.
There are different types of insolvency. Let’s briefly discuss the two most common.
Balance sheet insolvency
Balance sheet insolvency, which is also known as accounting insolvency, occurs when debts exceed assets. When that’s the case, it can be difficult to meet payroll, pay suppliers, make lease and essentially to keep the business running.
If a business owner may be able to arrange with at least some creditors to make installment payments. This is better for creditors than getting nothing, which is what could happen in bankruptcy.
It helps if a business owner has a good credit history and is going through a rough patch. It also helps if they have a plan to get out of insolvency.
Cash flow insolvency
Cash flow insolvency is when a business’s assets exceed its liabilities, but there’s a cash flow problem. They don’t have enough liquid assets to pay their creditors on time.
The owners often have to liquidate some of their fixed assets (like real estate and equipment) to pay their debts. Being able to do this and still stay in business, however, can be a tricky endeavor.
Any business owner facing insolvency is smart to get professional guidance to learn more about their options for saving their business. This may include bankruptcy. By doing this, they can determine the best way forward.