What Is Insolvency?
A company is deemed to be insolvent when a company cannot pay the financial debts owed to creditors when they become due (cash flow insolvency); or when a company’s total liabilities exceed its assets (balance sheet insolvency).
Insolvency can arise from many situations, such as:
- Poor cash management;
- A reduction in revenues;
- An increase in expenses;
- Unexpected events such as litigation; and
- Change in market conditions.
What Can Companies Do When They Become Insolvent?
When a company cannot pay its debts when they become due, it may attempt to arrange a financial compromise, like paying an agreed-upon lesser amount over a period of time, or consolidate debts with more favorable terms.
If a debtor and creditor(s) can’t agree on a repayment arrangement, it may require court intervention, which can be initiated by either the debtor or a creditor. When this situation arises, a debtor may have to liquidate assets to pay outstanding debts.
What Should You Do When Facing Insolvency?
If your business is facing insolvency, you can consider restructuring the debt or proposing a repayment plan. However, if you want to avoid the risk of losing your assets, you must reach an agreed-upon compromise with your creditor(s). The fewer creditors a company has, the easier this is to accomplish. In most situations, it is best to attempt to consolidate debts as much as possible to give the negotiations a greater chance of success.
What Are the Two Types of Insolvency?
The two main types of insolvency include cash-flow and balance-sheet insolvency.
Cash-Flow Insolvency
Cash-flow insolvency occurs when an entity cannot pay its debts when they become due.
Balance-Sheet Insolvency
Balance-sheet insolvency describes an entity where liabilities exceed assets. In other words, the company is said to have a negative net worth.
Navigating an insolvent company is a complicated process. Further, the fiduciary duties of the management team and board of directors change when a company is in the zone of insolvency. As a result, a company in either a cash flow or balance sheet insolvent situation should consult with a professional to help them successfully navigate a successful outcome.
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