A lot of people think of bankruptcy and insolvency as the same thing. Some think insolvency always leads to bankruptcy. Neither of these things are true. A business is considered insolvent if it can’t pay its bills or other financial obligations on time. Insolvency can lead to bankruptcy, but it doesn’t always. A business owner may be able to restructure their debt and prevent the need to file for bankruptcy.
If a business owner can reach out to a creditor to arrange to pay off their debt in installments, for example, they may prevent the creditor from initiating insolvency proceedings. Creditors may be agreeable to this if they believe the business owner will eventually pay what they owe or pay more than the creditor would get if the business went into bankruptcy.
It is important to understand the different types of insolvency before determining the best way to deal with it.
Balance sheet vs. cash flow insolvency
What’s commonly known as balance sheet or accounting insolvency is particularly serious because it means a business’s debts exceed its assets. The business can’t pay its employees, suppliers, landlord and others – at least not on time.
Cash-flow or equitable insolvency is when a business’s assets may be valued at more than its liabilities, but there aren’t enough liquid assets to pay its debts. It could be a matter of timing. A business may be expecting an influx of payments or increased sales, but it doesn’t happen in time to cover its current obligations, like payroll and bills.
If a business has more assets than liabilities, but those assets are fixed, the owner may be able to liquidate a few fixed assets (like selling off inventory). If a business’s assets are tied up in real estate or other assets that are difficult to liquidate without harming the business’s operations, liquidation may not be an option in the short term.
Regardless of which type of insolvency a business owner is facing, it is important for them to understand the options they have for debt relief – including bankruptcy – before deciding on a path forward. Seeking legal guidance may help a business owner make better decisions when their business is in financial distress.