When you are not able to pay money on time to a company or a person that you owe, you go to the state called Insolvency. Now you may think that this is the same thing as becoming bankrupt. But that’s wrong. They are completely different. Without being bankrupt, one can become insolvent but without being insolvent one cannot become bankrupt. Bankruptcy is made to solve the problem called insolvency.
When you are unable to pay the due debts, it is insolvency. There are many ways that can resolve insolvency like increasing earning or borrowing money to pay the due debt. Or, you can go for a settlement plan or negotiate the debt that is due to the creditors.
When you fail with all the other attempts to pay the due debts, you become bankrupt.
What is insolvency?
To explain in detail, there are two types of insolvency. Cash-flow insolvency and balance-sheet insolvency. If you do not have money and that is why you are unable to pay the due debt, then that is termed cash-flow insolvency. When the scenario is like your debts exceed your assets, then the situation is called balance-sheet insolvency.
In the case of cash-flow insolvency, a person is not able to pay the debt because he does not have money for that. In the second case, i.e. balance-sheet insolvency, a person may pay the debt, but with time, he gets financially collapsed. The financial condition of the person will exhaust by paying debts and will finally lead to the state of cash-flow insolvency.
When a creditor attempts to collect the debt and the person who owes the money is unable to pay within time, insolvency becomes an issue. Debt collection efforts come into question when the person fails to pay the debt. As an example, if you are unable to pay the mortgage of your house, you’ll be a defaulter and that may take you to foreclosure soon. The debt collectors will come to you if you do not pay the minimum monthly payments on your credit cards and do not try to fix the problem with the credit card company.
Cash Flow Insolvency
You become cash-flow insolvent when you are not able to pay the debt because of your financial condition. Doctors might call insolvency an acute condition if it were a medical issue. Many people can assume that they are going to go through a bad financial condition in the future. You can say this is a chronic problem. But until they are able to pay their bills, they are not cash flow insolvent. The problem will not become a personal crisis until you pay the bills on time. It does not matter if you are going through a financial problem.
Both businesses and individuals get affected by cash flow insolvency. When they have failed to pay the debt in all other ways, cash-flow insolvency occurs. You can avoid cash flow insolvency by liquidating an asset when your credit card payment is due. It is possible that the situation will come when there will be no more assets to liquidate or you will not have any places for borrowing money and you are not earning enough money to pay your debts. Then, with the creditors who owe you the money, you have to negotiate a payment agreement. You may have to do that through a debt management firm or directly.
You have to go through a cash flow test to determine what to do about this kind of insolvency. The debtor will analyze your current and future cash flow to decide whether you will be able to pay your debts with the money you earn or not. You may be insolvent temporarily if you are having the chance of gathering money in a few months. But there is no easy way out of insolvency if you have already sold all the assets that you had and you are not earning enough money to pay the debt. With the help of this analysis, you will be able to decide if you should file for bankruptcy protection or request a debt settlement.
Balance Sheet Insolvency
Most of the time, businesses go through a balance sheet insolvency test to determine if the time has come to file bankruptcy. The businesses analyze their assets, inflows, and outflows to determine the current financial situation. If a company’s assets are worth less than the money they have to pay and inflows are less than their outflows, the company might be able to file for bankruptcy. But if the company has assets like a store location or a truck that can be sold, the creditors will use those assets and cover debts. They can dismiss the business by selling all of its assets to cover debts.
The business operations will be examined by the financial advisors and they will suggest reducing debt and a course of action. The company can keep continuing the business if it can assure its creditors that it is going to make a good inflow in the future.
If a company has got non-liquid assets worth more than the debt it owes, it can be a balance sheet solvent despite being cash flow insolvent. The scenario can be the exact opposite also. If a company’s due debt is more than its assets and the revenue it is generating is enough for meeting its immediate financial commitment, the company can be cash-flow solvent despite being balance sheet insolvent. There are many businesses in this state, who hold long-term debt but operate regularly.
Some Reasons for Insolvency
There are a lot of reasons for which businesses and individuals become insolvent. Here we are stating the most common reasons for which insolvency occurs.
- Medical bills.
- Losing a job or reduction of salary.
- Overuse of the credit card.
- Monetary carelessness.
By all means, insolvency is a state where you have to go through financial distress. You may have to sell your assets to get rid of the insolvency.