Insolvency is a state of affairs on which an entity may either emerge or cease, in which the value of the asset is less than the value of liabilities and is unable to honor its debt and lead to insolvency resolution proceedings, which if successful, the entity is not declared bankrupt.
In simple terms, a firm is called insolvent when it isn’t able to meet its financial obligations. In other words, when a firm’s total liabilities exceed its total assets, we call the firm as an insolvent entity.
The basic reason for which a firm becomes insolvent is that it takes on too many debts. A firm takes debt for two reasons. First, the firm wants to invest in a new project or expand the business (e.g. enter a new market). Second, the firm wants to increase its financial leverage.
Too much of anything doesn’t yield good results. That’s why, when a firm takes on too much debt, it can’t meet its financial obligation and is called insolvent.
But they don’t give up so easily. Who likes to be called insolvent? That’s why they try to raise capital from other sources, sell off some of the assets, and try to remain afloat for some time. However, if a load of debt is too much that nothing changes the equation; the firm gets compelled to file for bankruptcy.
Example – Toys R Us
The most recent Insolvency example is that of the British unit of Toys R Us has gone into insolvency administration, putting around 3200 jobs at risk. Toys R Us has been losing business to online retailers and has been heavily leveraged.
Insolvency vs Bankruptcy – Is it the Same?
It turns out that insolvency vs bankruptcy are similar concepts, but not exactly the same.
- Insolvency is when a company is unable to pay its due when it’s time.
- Bankruptcy is when the court declares the company as insolvent.
So from one point of view, the insolvency of a company triggers bankruptcy. Before a company becomes insolvent, it can’t be declared bankrupt.
At the same time, we can bring in the term “liquidation”. How is liquidation related to insolvency?
If a company becomes insolvent and it is declared bankrupt, it’s time to liquidate the company. But to liquidate a company, it doesn’t always need to become insolvent. If the board of members of a company decides that it’s time to liquidate because the company has achieved its purpose, then a company will go through a process of liquidation, but actually, the company isn’t insolvent, to begin with.
How to ensure that a company doesn’t become insolvent?
In business, there are two kinds of factors that dictate the future prospect.
- The first kind of factors are controllable factors where you can improve your bottom line, you can understand the risk of taking too much debt, and you can produce more to increase your sales.
- The second kind of factor is uncontrollable factors where you don’t have any control. The global economic crash, political issues, industrial outrage, etc. are factors that you can do nothing about.
For the first kind of factor, you always need to be aware. As a business owner, you need to know how you’re utilizing your funds, how the money is coming in and what would be the future cash flows.
For the second kind of factor, you always need to create a contingency plan. If you prepare your business for any emergent situation, you would stay afloat even during terrible mishaps.
Companies don’t become insolvent just because they go out of money. Companies become insolvent because they don’t pay attention to the following things –
- The cash inflows of the company
- The future cash flows
- The total assets
- The liabilities piling up
- Increased expenses
- Decreased production
- Poor revenue
- Contingency plans
If a company makes sure that they pay heed to the above things on a regular basis, rarely they would go out of money. If they know how much they want to allocate in overhead costs and how much debt they can bear, the rest would be taken care of.
Can insolvency be a measure to avoid paying creditors?
This is a new strategy for a few phoenix firms to build up their assets and completely remove their liabilities.
- The directors of many firms use insolvency to abuse the whole system. They showcase their insolvency so that they don’t need to pay off the debt to the creditors. Then they appoint an administrator and in front of him, the whole assets of the company are sold.
- Since after insolvency, the company can legally start up again, these firms do the same. They start the same company under a different name. They buy all the assets they have sold and avoided the creditors completely. And as a result, they don’t need to pay anything to the creditors.
- This system is called the pre-pack administration.
If you’re a creditor/investor, you need to do your own diligence before you ever invest in a company.
This has been a guide to what is Insolvency along with practical examples. We also discuss differences between insolvency vs bankruptcy and top strategies that companies can adopt to ensure they don’t get insolvent. You may also have a look at the following articles on Corporate Finance –