Insolvency refers to a person or business that cannot pay debts or has liabilities exceeding assets, while bankruptcy is a formal legal concept where the government intervenes to settle debts. Insolvency can lead to bankruptcy, but not always. There are two types of insolvency: cash flow and balance sheet. Bankruptcy can severely damage credit for years, and it is important to seek financial advice as soon as negative balances show up.
While bankruptcy and insolvency are sometimes used interchangeably, they are actually very distinct terms. Insolvency can lead to bankruptcy, but it is an informal definition that describes a person who cannot pay debts or who has liabilities that exceed assets. Bankruptcy is a formal legal concept in which the government has intervened to settle the debts of an insolvent person or business.
Bankruptcy and insolvency are often linked, as insolvency can lead to formal bankruptcy proceedings. However, in some cases, a business may be able to operate without fear of bankruptcy despite being technically insolvent at the moment. To understand the relationship between bankruptcy and insolvency, it is important to understand the exact state of insolvency.
There are two main types of insolvency: cash flow and balance sheet. Cash flow default is generally a major problem, as it means that an individual or business is unable to pay debts when due. This can very quickly lead to creditors filing for bankruptcy proceedings against the debtor, known as involuntary bankruptcy.
Balance sheet default occurs when a company’s net assets are worth less than its net liabilities. While this can be bad in the long run, as long as cash flow revenues meet debt obligations, a business is relatively safe from bankruptcy. Most businesses start out on negative balance sheets, as they take out loans to buy equipment, rent premises, and hire staff before they can make any money. As long as the debts owed are long-term debts and regular payments are made, it is typically not necessary for a business to have the assets to pay off all debts at once.
Circumstances leading to bankruptcy and insolvency may be the result of corporate mismanagement, an unexpected change in the market, a recession or even a natural disaster. Whatever the cause, filing for bankruptcy is usually the result of an obvious insolvency, at least in terms of cash flow. When debtors default, creditors tend to become increasingly vehement in their insistence on payment. When it becomes clear to the debtor that he has no way to catch up with the liabilities, it may be time to file for bankruptcy and ask the government for help. Bankruptcy, therefore, is the process of legally defining a financial situation as insolvent.
@hile insolvency may have no adverse effect on credit, as long as payments are made, bankruptcy can severely damage credit for many years. When bankruptcy is determined, a person may find it nearly impossible to qualify for mortgage, loan, credit card, or refinance programs. In some regions, when bankruptcy is used to pay off debts, it may include wage garnishment to repay creditors. Bankruptcy and insolvency aren’t always inevitable in all cases, however, and many financial experts recommend getting good financial advice as soon as negative balances show up.
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