Insolvency is when a business cannot pay its bills and debts exceed assets and cash flow. It can lead to bankruptcy, but businesses can take steps to remain financially solvent, such as borrowing money or selling assets. Takeover by a larger corporation is also an option. Shareholders may have to decide whether to sell their shares or wait for the company to recover.
Insolvency is generally defined as a financial state in which a business can no longer pay its bills and other obligations on time. This occurs when liabilities or debts exceed assets and cash flow. Once a business becomes insolvent, it must take immediate steps to generate cash and pay off or renegotiate current debts. Businesses that cannot successfully extricate themselves from this condition often face bankruptcy proceedings, receivership, or liquidation of all assets.
Commonly confused with bankruptcy, insolvency is not much different. Both conditions deal with liabilities that exceed assets, but insolvency is a state of bankruptcy and bankruptcy is a matter of law. Businesses can be insolvent but not legally bankrupt. Insolvency can lead to bankruptcy, but the condition can also be temporary and repairable without legal protection from creditors.
Businesses facing the possibility of insolvency can take steps to remain financially solvent. Using existing lines of credit to borrow money is one way to avoid this, but it also creates more liability and new repayment terms. Selling assets to other companies is also a common hedge against the condition. Consumers may notice a local grocery store change hands, for example. The original supermarket chain may be reaching insolvency and selling 30 or 40 of its local stores to generate immediate cash for timely debt repayment.
Another option to avoid insolvency is takeover by a larger corporation. It is not unusual for major conglomerates to seek out small but commercially viable companies for takeover or acquisition proceedings. Even if the smallest company is currently flirting with insolvency, the rights to its exclusive product lines may be valuable enough to save it from financial ruin. This happens quite often in the wholesale food industry. Struggling makers of a popular product may agree to sell all their assets to a better-funded corporation.
Insolvency does not necessarily lead to bankruptcy, but all companies in bankruptcy are also considered insolvent. Once an insolvency announcement is made, shareholders may have to decide whether or not to sell their shares or remain with the company until it can recover its financial position.
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