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An unpleasant situation for any company or individual to be in, insolvency is important to understand not just for business owners. It is a possible financial threat all individuals may face. In this wiki entry, learn all about insolvency: what it is, examples of both types of insolvency, and how to avoid or get out of it.
Insolvency in a nutshell
- Insolvency is a state of financial distress for an individual or company, in which that entity is no longer able to meet financial obligations laid out between themselves and any number of lenders
- Examples include expensive purchases such as a house or car which are often paid in instalments, and the buyer is no longer able to meet those payments due to financial fluctuations
- Insolvency differs from bankruptcy, default, and illiquidity in crucial ways
- There are many ways to avoid or remove oneself from a state of insolvency, including an overhaul of accounting procedures, proper financial planning, and liquidating assets
What is insolvency?
Insolvency is a state of financial distress for an individual or company. It occurs when that entity is no longer able to meet the financial obligations they have agreed upon with their lenders or creditors. In short, they cannot pay their bills.
When insolvency proceedings are initiated, the creditor who is not being paid properly may take legal action against the entity that has fallen behind on its payments. This can lead to liquidation of assets by the entity against whom the proceedings have been initiated, restructuring of debt, and damages to the entity’s credit rating.
An individual may enter into insolvency when they own an expensive car and large house and run into financial distress. An expensive divorce, job demotion or redundancy, unexpected illness or injury may drastically alter the person’s financial situation. The payments they are required to put down on the house or car then become much too steep for their newly altered financial situation and they will have to enter an insolvency situation and work out how to proceed from there.
For a company to enter insolvency, it may have debts to repay to lenders on the 15th of every month and through poor business decisions or bad seasons, the company begins to fall behind on its payments. This causes the company’s cash flow to suffer and when the 15th comes around again, they are unable to make their repayments. In this case, the company becomes insolvent to a certain degree.
Insolvency is one of a few financial situations in which businesses and individuals may find themselves. It’s important to distinguish between these scenarios so as to fully understand the crucial ways in which they differ from each other:
- Default: payment deadlines have been missed and the debtor is not adhering to the contractual agreements laid out between debtor and creditor
- Illiquidity: the debtor’s assets and cash are insufficient to continue covering the remainder of the payments in the financial contract
- Insolvency: the individual or company is in a situation where they are unable to cover the various debts they owe to creditors
- Bankruptcy: seeking relief from debts they are unable to pay, a company or individual can file for bankruptcy, involving a court order which may be initiated by the debtor
Avoiding or resolving insolvency
For an individual, making reasonable purchases and avoiding payment plans that they can only barely afford will help to stay out of insolvency. Financial planning and forecasting are essential for the individual to stay out of insolvency.
For companies, good management of business finances will help to keep on top of insolvency. Updating one’s accounting software, outsourcing certain responsibilities, and planning ahead are all important aspects of finance management for businesses.
Finding oneself in the insolvency or one’s enterprise becoming insolvent is not the end in either case. Liquidating assets can provide fast cash to pay off creditors, while restructuring of debts can alter the financial agreement for both parties to better suit the insolvent entity. Taking new loans to pay off overdue ones can partially solve the problem, however, confidence in one’s future financial situation to pay off new debts is necessary. Otherwise, borrowing will only exacerbate the situation.