Insolvency is a temporary state where an entity is unable to meet debt and financial obligations. The liabilities of insolvent individuals or businesses surpass their assets. Insolvency is a financial condition that can lead to bankruptcy.
Bankruptcy, on the other hand, is a legal status. But insolvent individuals or businesses can try and avoid bankruptcy by increasing income and reducing expenses. Specialized insolvency practitioners restructure liabilities and debts. Insolvency does not affect credit ratings. But if an insolvent individual or business files for bankruptcy, it will affect credit ratingsCredit RatingsCredit rating process is the process in which a credit rating agency (preferably third party) analyzes a security and rates it accordingly so that the stakeholders can make their investing decisions..
Table of contents
- Insolvency Meaning
- Insolvency is a temporary state where an individual or a business entity encounters financial problems due to a shortage of cash.
- The insolvency proceedings include administration, liquidation, receivership, and voluntary arrangement.
- Insolvency and bankruptcy are two different terms; the former can lead to the latter. An induvial or firm declares bankruptcy in a court of law by filing for it. In doing so, the individual or firm declares that they won’t be able to pay their debts any further.
Insolvency is also knowns as administration. It is a repairable condition where a person or company’s total assetsTotal AssetsTotal Assets is the sum of a company's current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equity are deficient in meeting liabilitiesLiabilitiesLiability is a financial obligation as a result of any past event which is a legal binding. Settling of a liability requires an outflow of an economic resource mostly money, and these are shown in the balance of the company.. The insolvency practitioners restructure the corporate liabilities and debtsDebtsDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state.. Simultaneously they try to increase income.
In business, two different factors dictate the prospect:
- The controllable factors are where one can improve the bottom lineBottom LineThe bottom line refers to the net earnings or profit a company generates from its business operations in a particular accounting period that appears at the end of the income statement. A company adopts strategies to reduce costs or raise income to improve its bottom line. . Business owners have to understand the risk of taking too much debt. Businesses at all times should be aware of how they are utilizing funds. They have to track the money coming in and anticipate future cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. .
- Additionally, businesses need to plan for uncontrollable elements like global economic crashes, political issues, and industrial outrage. There has to be a contingency plan in place. Businesses that plan for emergencies stay afloat even during terrible mishaps.
The owners of many insolvent firms abuse the system and take advantage of bankruptcy laws. They become insolvent so that they don’t have to pay back debts. Then they appoint an administrator to sell company assets. This practice is known as a pre-pack administration. After this, the company can legally start up again. Instead, they start the same firm under a different name. They buy back all the assets they sold and avoid the creditorsCreditorsA creditor refers to a party involving an individual, institution, or the government that extends credit or lends goods, property, services, or money to another party known as a debtor. The credit made through a legal contract guarantees repayment within a specified period as mutually agreed upon by both parties. altogether.
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Video on Solvency
Let us now discuss the example of two real-life insolvent companies:
#1 – Toys R Us
The British unit of “Toys R Us” went into administration, putting 3200 jobs at risk. Toys R Us had been losing business to online retailers and had been heavily leveraged.
#2 – Global Brands Group USA
North America; Global Brands Group filed for bankruptcyBankruptcyBankruptcy refers to the legal procedure of declaring an individual or a business as bankrupt. when its sales fell by 44% by the end of March 2021 amidst the Covid situation. Subsequently, the company sold off various assets, including Aquatalia and other brands.
Factors Leading to Insolvency
Businesses become insolvent due to the following factors:
- Investment Project Failures: One of the biggest reasons behind businesses becoming insolvent is an improper investment. It is a failure of the business expansion strategy. If such a business investment becomes unsuccessful, the company faces massive loss or gets over-burdened with debts. But a lack of analysis or planning is at the root of bad financial decisions.
- Poor Planning and Budgeting: Many organizations lack proper financial planningFinancial PlanningFinancial planning is a structured approach to understanding your current and future financial goals and then taking the necessary measures to accomplish them. Because this does not begin and end in a specific time frame, it is referred to as an ongoing process.. The budget estimation is inefficient. Partially this is down to cost-cutting. Firms fail to hire competent managers. In the end, they pay the hefty price of losing assets and capital.
- Improper Debt Management and Excessive Borrowings: Sometimes, companies get over-leveraged, and the cost of borrowings exceeds earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments.. This happens when the management ignores the ability to repay loans.
- Weak Debt Recovery Mechanism: Companies often allow a lenient credit periodCredit PeriodCredit period refers to the duration of time that a seller gives the buyer to pay off the amount of the product that he or she purchased from the seller. It consists of three components - credit analysis, credit/sales terms and collection policy. to their debtors for a short time. During that phase, the company is insolvent as they lack cash flow. Moreover, some of these organizations don’t have a proper system for recovering customer dues and creating bad debtsBad DebtsBad Debts can be described as unforeseen loss incurred by a business organization on account of non-fulfillment of agreed terms and conditions on account of sale of goods or services or repayment of any loan or other obligation.. Also, at times the biggest client of the firm, who owes a substantial amount, goes bankrupt.
- Ignoring Competitors and Framing Incompetent Business Strategy: When an organization prepares the business strategy in isolation, i.e., not considering the competitors’ moves, it adversely affects the business sales and profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.. Such losses make a company insolvent.
- Inefficient Finance Department and Managers: Human resource is crucial in any business. Often companies hire a team of poorly skilled finance executives. They lack experience, which is why their decision-making quickly exhausts the firm’s assets and financial resources.
Alternatively, a higher cost of production caused by a change in suppliers can render a business insolvent. Similarly, a shift in consumer preference can bring down sales, and the firms become insolvent. Some of these factors cannot be anticipated and are attributed to the standard market riskMarket RiskMarket risk is the risk that an investor faces due to the decrease in the market value of a financial product that affects the whole market and is not limited to a particular economic commodity. It is often called systematic risk. of doing business.
Individuals become insolvent due to accidents, loss of employment, demotion, medical expenses, improper finance management, credit card debts, and business losses. Sometimes individuals lose a lot of money by getting sued. Consequently, these individuals can become insolvent.
Insolvency Types and Tests
Following are the relevant tests determining financial distressFinancial DistressFinancial Distress is a situation in which an organization or any individual is not capable enough to honor its financial obligations as a result of insufficient revenue. It is usually the result of high fixed costs, obsolete technology, high debt, improper planning and budgeting, and poor management, and it can eventually lead to insolvency or bankruptcy.:
#1 – Balance Sheet Insolvency
The balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company. records the complete list of the corporate assets and liabilities. So, when the overall liabilities go beyond the fair valuation of its total assets, the company becomes insolvent. In such scenarios, the net assetsNet AssetsThe net asset on the balance sheet is the amount by which your total assets exceed your total liabilities and is calculated by simply adding what you own (assets) and subtract it from whatever you owe (liabilities). It is commonly known as net worth (NW). tend to be negative. Eventually, most of these companies go bankrupt.
The balance sheet test examines net assets by deducting the total liabilities from the total assets. Both the variables are fair market values (here, exemptions and the loss from fraudulent practices are not taken into consideration). The result so derived is a negative value. Therefore, it requires expert intervention to rescue the company; otherwise, it will lead to liquidationLiquidationLiquidation is the process of winding up a business or a segment of the business by selling off its assets. The amount realized by this is used to pay off the creditors and all other liabilities of the business in a specific order..
#2 – Cash Flow Insolvency
It is a state where the company faces a cash shortage. As a result, the company is unable to pay creditors and clear operational debts. Here, the current liabilities exceed the liquid assets of the firm, creating a negative cash flowNegative Cash FlowNegative cash flow refers to the situation when cash spending of the company is more than cash generation in a particular period under consideration. This implies that the total cash inflow from the various activities under consideration is less than the total outflow during the same period. situation.
It is possible to anticipate such problems before they occur. An ability to pay test or the cash flow test can be conducted. Cash outflows are subtracted from the cash inflows, and the outcome is a negative value. This situation is under managerial control. It can be resolved by planning relevant payment periods for creditors and debtorsDebtorsA debtor is a borrower who is liable to pay a certain sum to a credit supplier such as a bank, credit card company or goods supplier. The borrower could be an individual like a home loan seeker or a corporate body borrowing funds for business expansion. . Additionally, the terms and conditions need to be revisited.
An insolvent organization can seek a practitioner’s advice for dealing with such circumstances. Following are four ways an insolvent company can proceed with:
- Administration: The foremost thing an expert does is pull the insolvent organization out through debt restructuring.
- Liquidation: This is a dissolution strategy, where the company’s overall cash, funds, and assets are liquidated to pay the creditors and the lenders.
- Receivership: Here, the bank or the court appoints a receiver to take hold of corporate assets; both tangible and intangible. This is done to meet financial liabilitiesFinancial LiabilitiesFinancial Liabilities for business are like credit cards for an individual. In simple terms, a financial liability is a contractual obligation that needs to be settled in cash or any other financial asset and are very useful in the sense that the company can employ “others’ money” in order to finance its own business-related activities for some time period which lasts only when the liability becomes due. The liabilities could be of two types, short term and long term..
- Company Voluntary Arrangement: This is a method where the firm’s creditors agree receiving only a proportion of the debts. To emulate this provision, 75% of the creditors have to vote in favor.
Insolvency vs. Bankruptcy
Insolvency is the trigger that causes bankruptcy. But it may not always lead to bankruptcy. Insolvent firms can rectify their financial condition by increasing income or reducing expenses.
Insolvency is a negative financial situation where the individual or corporate assets fall short of meeting the obligations. Bankruptcy, on the other hand, is the consequence of being insolvent.
It is a temporary state. A firm being insolvent, therefore, has no impact on the credit ratings. Bankruptcy, though, involves the court and is thus more serious. Bankruptcy is a permanent record and does affect credit scores.
Frequently Asked Questions (FAQs)
A debt relief or insolvency order is initially issued for one year and is called a moratorium. Post the moratorium period, the insolvent individual or firm is released from the imposed restrictions.
Following reasons led to insolvency:
• Excessive credit and inability to recover customer dues or debts
• Poorly managed cash flows and long-term finances
• Improper budgeting
• Over-indebtedness and borrowings
• Incompetent business strategy and ignoring competitors
• Investment failures.
The state of insolvency doesn’t much affect the credit rating of a person or company until it leads to bankruptcy. However, bad credit scores due to bankruptcy can lead to difficulty in borrowing money, availing of a credit card facility, or opening a current account. An insolvent individual or organization may even end up taking on expensive debts.
This has been a guide to insolvency and its meaning. Here we discuss the insolvency process, types, tests examples, and factors leading up to it. You may also have a look at the following articles on Corporate Finance –