Insolvency: Definition & Meaning
Insolvency is the situation where a firm is unable to meet its debt obligations when they become due. This could be due to a lack of liquidity or to liabilities exceeding overall assets.
The number of insolvencies has been on the rise, with 1,783 companies applying for insolvency procedures in February 2023, a 33% increase from 2020.
Insolvency: Example
An example of insolvency is when the British unit of the company ‘Toys R Us’ went insolvent owing to cash flow troubles due to steep competition from online retailers and high leverage. The company went into administration because it could no longer service its debt obligations.
What are the two types of insolvency?
There are two types of insolvency: balance sheet insolvency and cash flow insolvency. We explain them in detail as follows:
Balance-sheet insolvency
It is the state where a company’s liabilities outstrip its assets, making it difficult to make debt payments. It also accounts for prospective and contingent liabilities.
However, there may be instances when the firm has the cash to make an immediate bill payment, but it is not permitted to do so unless the creditors receive the payment.
Balance sheet insolvency is also called technical insolvency, as it implies that the company has negative net assets (liabilities exceed assets).
Cash-flow insolvency
It refers to the situation when a company does not have adequate liquidity to pay off its debts as they mature. As per the Insolvency Act 2006, if a company does not pay its creditors that are owed over £750 in three weeks, it will be considered cash flow insolvent.
In other words, even if a company’s assets exceed its liabilities, it may be called insolvent if it does not have sufficient cash to meet its immediate debt payments. This means a company can be balance sheet solvent and yet be cash flow insolvent.
See also: Cash Flow: definition, calculation, principle, all you need to know!
Insolvency vs Bankruptcy
Insolvency and bankruptcy are not interchangeable terms. Insolvency is the inability of an individual or a firm to pay off their debt obligations. It generally applies to companies and partnership firms.
In contrast, bankruptcy involves a legal process. It is the situation when a court determines that an individual can no longer meet their debt and can seek relief from their obligations. Bankruptcy only applies to natural persons, such as individuals and traders. Creditors who are owed over £5,000 can apply for bankruptcy against their debtor.
What happens during insolvency?
When a company fails to make debt payments, it is declared insolvent. At this stage, it can go through different processes.
- Company voluntary arrangement (CVA): It is an agreement to pay a lower proportion of the outstanding debt between the creditors and the company over an agreed-upon term. At the end of the ordained period, the unpaid debt is written off. But if a firm fails to sign a CVA, it must undergo liquidation.
- Administration: It is the procedure where an administrator, in the form of an insolvency professional, is appointed to restructure a firm’s debt and operations to ensure continued functionality. The administrator may also choose to reach a CVA with creditors or liquidate assets to pay off preferential creditors.
- Administrative receivership: In this scenario, a floating charge holder, like a bank, appoints an administrative receiver to help recover the amount owed to it. Such an administrative receiver only recoups an amount sufficient to pay off preferential creditors and ignores unsecured creditors.
- Compulsory liquidation: An enterprise can be mandatorily wound up on a court’s order after creditors fail to recover their money through statutory demand or court judgement. The liquidator will dispose of assets and distribute the funds among the creditors.
- Creditors’ voluntary liquidation (CVL): An insolvent company can also be wound up by initiating a liquidation process through a shareholder resolution. But this process is legally acceptable only after the creditors have been given the option to choose their own liquidator.
How can a cash flow forecast help a business to avoid insolvency?
The initial signs of a company experiencing financial distress materialise in the form of cash inflow shortages. A cash flow test can help businesses determine whether they are about to go bankrupt.
An insolvency cash flow test entails the determination of a company’s liquidity position and its ability to make payments reasonably into the future. For this, enterprises create a cash flow forecast that highlights the likelihood of any immediate or short-term cash squeezes that may keep the firm from making timely payments.
Watch this video to better manage your cash flow:
A cash flow forecast can also identify any issues with the payments cycle, such as customers’ delays in making invoice payments. It also helps companies assess their cash cycle, enabling them to take remedial action.
You may also like this article: How does liquidity management work and why is it so important?
Firms can also track their payments to their suppliers and employees with a cash flow forecast. Any delays in vendor payments can harm a firm’s operations, aggravating losses and worsening financial flows.
At times, even external stakeholders, including banks, demand cash flow forecasts while extending loans to make judgements about a firm’s liquidity management. So, effective cash flow management not only aids firms in staying on top of their liquidity position but also minimises the chances of going insolvent.
Key takeaways
Insolvency is the situation when a company can no longer make its debt payments. When a company’s liabilities supersede its assets, it is known to be balance-sheet insolvent. Insolvency in cash flow happens when a company has sufficient assets but lacks the liquidity to meet its immediate obligations. So, streamlining cash flows is an effective way to minimise the risk of going insolvent.
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