Debitoor Dictionary

Accounting terms explained in a simple way

Over 150 Articles for Founders and Entrepreneurs

  1. Balance sheet
  2. Assets
  3. Bookkeeping
  4. Liabilities
  5. Bankruptcy

Insolvency - What is insolvency?

Insolvency is the state that a company or individual enters when they are not able to pay their debts.

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When a business becomes insolvent, this means that their debts (liabilities) are greater than the value of their assets and income. In effect, they are not able to pay back money owed, either currently or in the future.

It is possible for a company to be insolvent even if their assets outweigh their liabilities if the assets are not easily converted to cash needed in order for the company to make the necessary payments.

When a person becomes insolvent, this is generally known as ‘bankruptcy’ and falls under an entirely different set of rules and necessary procedures.

How a company becomes insolvent

There are many ways that a company can find itself in the unfortunate situation of insolvency. However, there are a few common causes:

  • The business has not adjusted to keep up with the current market
  • Overly ambitious growth plans that deplete the company’s financial resources
  • Fraud
  • Improper or unqualified management
  • Lack of thorough bookkeeping

As a sole trader or small business owner, almost any of these can lead to insolvency. There are two tests that will generally reveal whether a company has become (or is at risk of becoming) insolvent.

Balance sheet test

Under the balance sheet test, a thorough overview of the company’s balance sheet should reveal whether the liabilities are larger than the assets either now or in the future, taking into account both expected and unexpected expenses.

Cash flow test

This test involves examining the company’s budget to determine whether there is enough cash or convertible assets to pay off the current and upcoming debts. When a business fails one or both of these tests, it is likely already experiencing or heading towards insolvency and should follow the necessary procedure.

The insolvency process

Once a business is declared insolvent, it’s important that it does what is necessary to prevent further depreciation of assets and depletion of cash. The ending aim of managing insolvency is to ensure that as much money is returned to investors and creditors as possible.

In some cases, it might be possible to bring the company back from insolvency. In this situation, the expertise of an insolvency practitioner is necessary. This professional can step in and determine what can be done to return the business to a solvent state.

In insolvency, the shareholders and directors can request the following out of court:

  • Liquidation of the business. This means the complete liquidation of all assets and cash accounts.

  • Administration, which involves restructuring of the business in an attempt to save it. A professional is given the role of managing the company.

  • Receivership, wherein a creditor or creditors, such as a bank or other investor, appoints an insolvency practitioner to manage the assets in order to pay off the debt as much as possible.

  • Company voluntary arrangement, where a contract is drawn up regarding the payment of debt after an agreement is made between the company and the creditors.

Some cases of insolvency might end up in court, in which case there are a number of further proceedings to manage the payment of debt with the aim of compulsory liquidation.

Preventing insolvency

The best way to prevent insolvency is to create realistic budgets, keep track of the finances of your business, and stay abreast of the market in which your company is operating.

While this might seem an oversimplification of the challenges faced by businesses at the brink of insolvency, there are resources available to help you keep on top of the pillars of running a business.

Online accounting & invoicing software like Debitoor provides an easy way for sole traders and small businesses to track and record their income and expenses from anywhere, the first step to ensuring your business stays solvent.