Some people think that insolvency and bankruptcy are just different names for the same thing. Still more assume that insolvency always leads to bankruptcy. Neither is true.
Business owners need to be able to recognize when they have reached insolvency and what type it is. This can help determine how best to proceed.
Under U.S. bankruptcy law, insolvency is a “financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at fair valuation.” Not all insolvency looks the same. Let’s look at the two most common types.
Accounting (balance sheet) insolvency
Accounting insolvency is the most straightforward type. Simply put, it occurs when a business’s debts exceed its assets (both liquid and non-liquid). That means even if a business sells off fixed assets like equipment and furniture, they won’t be worth enough to cover its debts.
That doesn’t necessarily mean all is lost. If a business owner has a solid plan to turn around their business, creditors may agree to accept payment in installments or even accept less than they’re owed. That can be better for them than the business filing for bankruptcy, in which case they may get less than that or even nothing.
Equitable (cash flow) insolvency
Equitable insolvency typically leaves a business owner with more options. It occurs when a business’s debts exceed its liquid assets, but not its overall assets. That means if a business is able to liquidate some fixed assets and still continue to operate, they may be able to get out from under their debt.
Any type of insolvency warrants taking steps as soon as possible to determine whether the business can be saved and – if so — what the options are for doing that. Getting experienced legal guidance is crucial.