Insolvency is universally considered a bad thing for a business, but what does the term actually mean? It’s sometimes used interchangeably with bankruptcy, but the two are actually different, although both usually spell major issues for companies going through them.
On an extremely simple level, insolvency means not having enough money to pay off your debts. However, in a legal sense there’s much more to it than that. Here’s what the term means in some of the main places you’re likely to do business around the world:
In the US, there are two main types of insolvency: cash flow and balance sheet. The former occurs when you owe money, but cannot pay off the debt due to a lack of funds. In contrast, balance sheet insolvency occurs when your business’ debts outweigh its assets. It’s possible to be one but not the other, or both at the same time.
For example, if your business has more debt than assets but enough regular revenue to pay off its immediate financial obligations, it would be cash flow solvent but balance sheet insolvent. This might not be a problem; you could have a large loan to pay off for instance, but are making more than enough to cover the interest.
Insolvency works in a very similar manner in the UK as in the US. However, there are a few different tests for whether or not a company is insolvent under British law. For example, a company is deemed unable to pay its debts if it hasn’t paid, secured or compounded a claim from a creditor that exceeds £750 (around $916) within three weeks of being served with a written demand for the money.
An option available to insolvent UK businesses is administration, whereby an administrator is appointed in an attempt to either save the business or pay off as many of its creditors as possible. This is usually used as an alternative to liquidation, but often ends with that process anyway.
While the German equivalent of cash flow insolvency is much the same as in the US, its form of balance sheet insolvency differs. To work out whether or not a business is over-indebted, a business continuation forecast will be made. If the company intends to continue trading and can show it will be able to stay in business for the current and next financial year, it’s likely to be able to remain classified as solvent.
If a business enters insolvency proceedings, the main focus will be to pay all its creditors by selling off assets and distributing the proceeds equally. It’s possible to withdraw from this process, such as by paying the debt of the creditor who initiated it, but not once proceedings have begun.
The definition of insolvency under French law is relatively simple: if a company cannot meet its currently due debts with its immediately available assets, it’s insolvent. This might seem harsh, but there’s a process known as “sauvegarde” (safeguard) that’s designed to restructure businesses that are still essentially cash flow solvent.
If a company’s rescue seems possible, it could go into rehabilitation. If this happens, management would prepare a plan to keep the business going, save as many jobs as possible and pay its creditors (in that order of priority), that would need to be approved by a court and its creditors. However, most commonly a liquidator is appointed in an attempt to achieve these three goals.