Understanding Insolvency

Society as a whole benefits when businesses and individuals stay solvent and contribute to the economy. There is a ripple effect on the society and families when businesses face financial death, and or individuals are saddled with the burden of high debt loads.
Insolvency is a financial state of being which can lead to bankruptcy but the condition may also be temporary and fixable without legal protection from creditors. Insolvency does not necessarily lead to bankruptcy, but all bankrupt debtors are considered insolvent.

While bankruptcy is a legal process that serves the purpose of solving insolvency, insolvency is the legal term describing the situation of debtors who are unable to pay their debts. An insolvent person is not a bankrupt person until he or she chooses to file for bankruptcy; even the word “unable” in the definition of insolvent person does not mean “unwilling” to pay. Likewise if a debtor has enough funds and assets to meet his or her obligation but chooses not to do so, then he or she is not insolvent as per Bankruptcy & Insolvency Act (BIA).

Further in determining whether a business debtor is insolvent under the definition of insolvent person debtor, the balance sheet of the company is generally the starting point. In legal terminology, insolvency is the situation where the liabilities of a person or firm exceed their assets. In practice, however, insolvency is the situation where an entity cannot raise enough cash to meet its obligations, or to pay debts as they become due for payment.

Generally insolvency falls into two primary types: Cash Flow and Balance Sheet. Accounting insolvency is a different approach to standard insolvency. The latter involves a firm missing or being unable to make a debt-servicing payment, while the former examines the firm’s balance sheet.

In cash flow insolvency, the debtor suffers from a lack of financial liquidity making it impossible to pay debts as they fall due. This is the type of insolvency most individuals experience prior to filing for bankruptcy. In this situation person can no longer meet their debt obligations on time as they become due and thus are ‘cash-flow’ insolvent.

Balance sheet insolvency, on the other hand, involves having negative net assets, where one’s liabilities exceed their assets. In this situation where a person’s liabilities or legal entity’s debts exceeds their assets, is referred to as ‘balance-sheet’ insolvency.

Notably, insolvency is not the same as bankruptcy. For example, a business can be cash flow insolvent but balance sheet solvent, and as a result, would likely be unable to qualify for bankruptcy protection. Indeed, many businesses have negative net assets but remain cash flow solvent as their ongoing operations meet their regular debt obligations, helping them to avoid default.

There are many factors leading to insolvency, there are methods by which to tackle insolvency some of which are informal and other formal. Negotiating directly with creditors is an example of informal plan of action, and creditors are typically amenable to this direct approach because they understand cash flow issues arise with businesses and they want repayment instead of seeing the business filing for bankruptcy.

Restructuring of debts through negotiation with creditors is by far the best solution; the business debt restructuring plan on the other hand is more formal where the owner creates a proposal detailing how the debt may be restructured using the cost reduction or other plans for support. The proposal shows creditors how the business may produce enough cash flow for profitable operations while paying its debts.

A firm is technically insolvent if it cannot meet its current obligations as they come due, despite the value of its assets exceeding the value of its liabilities. A firm is legally insolvent if the value of its assets is less than the value of its liabilities. A firm is bankrupt if it is unable to pay its debts and files a bankruptcy petition. Solvency in such situation is measured with a simple liquidity ratio called the “current ratio.” but other equally effective determination are ratios such as “acid-test ratio”, “quick ratio” or “liquidity ratio.” The company may attempt to restructure the business to alleviate its debt obligations, or be placed in bankruptcy by the debtholders.

When a public company is unable to meet its debt obligations and files for protection under bankruptcy, it can reorganize its business in an attempt to become profitable, or it can close its operations, sell off its assets and use the proceeds to pay off its debts (a process called “liquidation”).

Then there is voluntary bankruptcy and involuntary bankruptcy. In a voluntary bankruptcy an insolvent debtor brings the petition to a court to declare bankruptcy because he or she is unable to pay off debts. The bankruptcy is intended to create an orderly and equitable settlement of the debtor’s obligations. Voluntary bankruptcy is typically commenced when a debtor finds no other solution to the financial situation.

Involuntary bankruptcy is requested by creditors who feel that they will not be paid if bankruptcy proceedings are not entered into, and therefore seek a legal requirement to force the debtor to pay. Insolvency occurs when a firm cannot meet its contractual financial obligations as they come due and these might include interest and principal payments on debt, payments on accounts payable and income taxes. It is advisable and highly recommended to use the services of a Licensed Insolvency Trustee to restructure company debts, or when thinking of filing for bankruptcy. Other options include making a consumer proposal to the creditors.

Bankruptcy risk describes the likelihood that a firm or an individual will become insolvent because of their inability to service their debt. According to Financial Post, in the past year alone over 120,000 Canadians declared themselves insolvent.

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About Syed Hussain

Syed Hussain, Ph.D: Banker, Bankruptcy Analyst, Forensic Accounting & Fraud Examiner, Cyber-Crime & Anti-Money Laundering Advisor, Internal Auditor & Counterterrorism Strategist . As an avid reader and traveler, the former air force pilot, likes to connect with like minded people and engage in intelligent conversations. He enjoys music, film and politics, as well as visiting museums, art galleries and air shows. Syed enjoys horse back riding and swimming. Besides English, he speaks other languages. At the end of the day, he can be found relaxing with a good beer and a fine meal.

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