Business Insolvency 101
What is insolvency in business?
A company is insolvent when it can’t pay its bills when they’re due or it has more liabilities than assets on its balance sheet.
A business in this state of financial distress can avoid liquidation by:
- reaching out to creditors directly to reach an informal agreement regarding payment terms and installments;
- putting together a proposal to illustrate how the company can restructure its debt while continuing to trade. This is covered by Chapter 11 of the US Bankruptcy Code.
Insolvency vs bankruptcy: the US Bankruptcy Code
Insolvency is the state of financial distress, whereas bankruptcy refers to the proceedings that can arise out of insolvency in order to resolve the situation.
The US Bankruptcy Code refers to more than one type of bankruptcy for insolvent companies—corporate restructure (chapter 11), as mentioned above, or liquidation (chapter 7).
When a chapter 11 petition is filed to the bankruptcy court, either by the debtor or a creditor, the debtor proposes a plan of reorganization to keep its business alive and pay creditors over time.
Affected creditors may vote on the plan, and the plan may be confirmed by the court if it satisfies all the requirements.
A chapter 7 bankruptcy petition, on the other hand, is for liquidation—also known as a straight bankruptcy. It entails the sale of a debtor's property and the distribution of the proceeds to creditors.
Insolvency proceedings in the UK
In the UK, businesses do not initiate bankruptcy proceedings. “Bankruptcy” is a term that is used only in relation to individuals who become insolvent.
UK business owners or Directors of insolvent companies have three steps they can take before action is taken to “wind up” (liquidate) the company:
- Reach out to creditors directly to reach an informal agreement regarding payment terms and installments.
- Enter into a Company Voluntary Arrangement (CVA) with creditors via an insolvency practitioner.
- Put the company into administration, which provides some respite from creditors while assets are sold and the business continues to operate.
A creditor might also force the company into administration, or administrative receivership, also known simply as “receivership”. The creditor appoints an “administrative receiver”, usually an insolvency practitioner, to recover the money owed to it. This does not need to involve the courts.
Types and signs of insolvency
The “types” of insolvency refer to the two main methods that insolvency is diagnosed in a company.
- Balance sheet insolvency
- Cash flow insolvency
Balance sheet insolvency test
Balance-sheet insolvency is when a company has more liabilities (debts) than assets.
Cash flow insolvency test
Cash-flow insolvency is when a company has enough assets to pay what is owed, but cannot free up enough cash to make the payment on time.
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