Insolvency is a prospect that no finance manager or business director wants to contemplate.
However, the unfortunate reality is that, if you find yourself in a position where you're struggling to pay debts and money you owe, it's best to do some research into insolvency so you're fully aware of the options available to you.
Insolvency is generally divided into two categories:
- Cash-flow insolvency: when you don't have sufficient cash or liquid assets to pay your debts, but do have other assets that could cover what you owe
- Balance sheet insolvency: when the liabilities on your balance sheet exceed your assets
There are various ways companies can attempt to handle these scenarios. Laws and processes will vary between nations, so it's advisable to do some research on how insolvency procedures work in your country.
Continuing to trade
Insolvency doesn't necessarily spell the end for the business since there are a number of things you can do to allow the company to continue trading.
One of the first steps could be to see if you can reach an informal agreement with creditors that allows you to change your debt repayment terms. This is sometimes the easiest way to manage the situation if you're experiencing temporary cash flow issues and there’s no immediate threat of legal action by creditors.
Contacting the individuals and organizations to which you owe money and discussing the situation as soon as possible can be one of the most constructive ways to approach insolvency.
Using the UK system as an example, another common insolvency option is a company voluntary agreement (CVA): a binding arrangement between a business and its creditors for payment of all, or part of, the firm's debts over a set period.
You can continue trading while the CVA is in place and afterwards.
Alternatively, the business could enter administration, which means it's handed over to an insolvency practitioner. This ensures your creditors can't take legal action to recover their debts or force the company into liquidation without legal permission.
The insolvency practitioner will come up with proposals to:
- Restore the company to a viable position
- Negotiate a CVA
- Sell the business, or gain more value from its assets than is likely to be realized in a liquidation
- Realize assets to pay preferential or secured creditors
Creditors can choose to support or oppose the administrator's proposals, potentially based on whether they could achieve a better result by forcing the company into liquidation.
For the business, one of the benefits of going into administration is that you may not have to pay all of your debts in full.
In Germany, an insolvency administrator (or the debtor, in the case of self-administration) can keep a business running during insolvency proceedings if there’s hope of finding an investor to acquire the company.
It's also possible for an insolvency administrator to gain additional financing if a lender agrees to provide it, or to generate liquidity by processing stocks or selling to customers, subject to supplier agreement.
If there are no viable options that would allow you to continue trading, the company could go into liquidation, which means it’ll stop doing business and employing people. The firm will also be removed from the business register in your home country.
The liquidation process works in different ways around the world. For example, in the US, it's governed by chapter 7 of the Bankruptcy Code, under which a bankrupt business (one that has entered into legal proceedings because of inability to pay its debts) is brought to an end and its assets are distributed to creditors.
The distribution is decided based on the following levels of priority:
- Secured creditors with collateral on loans to the business have the most senior claim. They can seize the collateral and sell it, and if this doesn't cover the debt, they can recoup the balance from any remaining liquid assets.
- Unsecured creditors such as bondholders, the government (in the case of unpaid taxes) and employees (unpaid wages or other obligations) are next in line.
- Shareholders receive any remaining assets.
Once the liquidation process is complete, all inventory and assets are sold off and the company's contracts and other affairs are finalized, the firm will no longer exist.
Actions that could be taken against you
It's important to be aware of the actions that creditors might take against the company if you become insolvent.
People or organizations seeking to recover money they’re owed could pursue actions such as:
- Seeking a court judgment to reclaim the debt
- Issuing a statutory demand (an official request for payment)
If your creditors are unable to recover their debts through these channels, they may apply to force the company into compulsory liquidation or administration.
You can make your own legal application to stop the business being forced into liquidation, which could allow you to take action of your own, such as entering into a CVA or voluntary administration.
Considering the wide range of processes, legal options and potential outcomes associated with insolvency, one of the wisest things you can do if you're concerned about the company's ability to pay its debts is to get professional advice from a:
- Qualified accountant
- Authorized insolvency practitioner
- Reputable financial adviser