What Is Insolvency and How Does It Differ from Bankruptcy?
The difference between bankruptcy and insolvency can be confusing. However, it’s important to understand the distinction, especially if you own or run a company.
Keep reading to take a look at insolvency and explore how it differs from bankruptcy.
What Is Insolvency?
Insolvency refers to an individual or company’s inability to pay debts when they fall due. In an insolvent situation, the party assets are insufficient to discharge outstanding monetary obligations at the creditors’ demand.
In other words, an individual is considered insolvent when their current assets do not exceed their total liabilities and obligations.
For instance, let’s say a company owes $1 million but only has $500,000 in equity. The company would be considered insolvent because of this negative net worth.
Insolvency Tests for a Business
As a company, you can determine if you’re insolvent by taking two tests.
- Balance Sheet: The balance sheet insolvency test determines if your liabilities are lesser than your assets. If your debts are higher than the assets, you’re insolvent.
- Cash-Flow: This method tests a company or individual’s ability to pay their debts. It’s also commonly called the “ability to pay” test.
What Causes Insolvency?
Insolvency may be caused by many factors, such as loss of a significant customer, financial crisis or severe illness of the business owner.
In these situations, a person cannot pay their debts, and interested parties are required to take action to protect their interests.
In some cases, an insolvent company can be saved through reorganization, while other companies may have to liquidate, depending on the circumstances.
Moreover, lawsuits can make a company insolvent. For instance, if a medical practice has to pay millions in compensation for a medical malpractice lawsuit, it may become insolvent due to the lack of funds.
Liquidation is a voluntary process in which a company will end certain business operations and sell all of its property to repay creditors.
In liquidation, only the company’s liabilities and not shareholders’ capital are reduced. The liquidator should apply for a release from personal accountability — known as a discharge –if they have diligently applied themselves to all aspects of the liquidation.
Shareholders will lose all of their investment if the company liquidates, but banks and other creditors may recover some of what they were owed when the company sells its assets.
Creditors have priority over any money remaining after a liquidation proceeding is completed.
However, there are also non-liquidation bankruptcy cases where you don’t have to sell anything.
Insolvency law exists to protect those creditors who are most directly affected, such as those with fixed financial interests in the debtor’s property, primarily secured creditors or unsecured trade suppliers.
What Is Bankruptcy?
Bankruptcy is a financial declaration in which a person or business can no longer pay for its debts. This may result from grave mismanagement of resources, emotions and/or time, or a ballooning debt which exceeds what the person or business can afford to pay.
Bankruptcy can be personal (for an individual), corporate or state. Worldwide, bankruptcy refers to financial institutions and encompasses individuals or businesses that cannot pay their debts.
In colloquial terms, such people are said to be: “broke,” “in the red’ or’ “underwater.”
How Does It Differ From Insolvency?
What is the difference between insolvency and bankruptcy? Insolvency is financial distress, leading to a company or person not being able to pay off their debts. Meanwhile, bankruptcy involves a court order depicting how the insolvent party can pay off the creditors.
In bankruptcy, an outside party such as a government agency will force the company to shut down until it can pay off its debts and obligations by selling other property it owns.
The court may also prevent management from paying itself wages during this time to distribute money toward the creditors. Likewise, the court order may also specify how the company has to sell its assets to pay the creditors.
The traditional means of dealing with debtors who cannot pay their debts involves negotiation between creditors and debtors, followed by a formal court proceeding known as a bankruptcy petition.
Insolvency is the first step towards bankruptcy. A company may be insolvent but not bankrupt. However, if insolvency extends for too long, the organization could become bankrupt.
Good To Know
Although insolvency differs from bankruptcy, it could be a precursor to bankruptcy. Therefore, as a business owner, it’s best to make financial reforms early in the process to prevent going bankrupt. But even if you do go bankrupt, know that it’s not the end. Many businesses recover from bankruptcy, and yours can too.
Our in-house research team and on-site financial experts work together to create content that’s accurate, impartial, and up to date. We fact-check every single statistic, quote and fact using trusted primary resources to make sure the information we provide is correct. You can learn more about GOBankingRates’ processes and standards in our editorial policy.
- IRS. 2021. "What if I Am Insolvent?"
- Forbes. 2020. "Understanding Chapter 13 Bankruptcy For Independent Business Owners In Need."
- United States Courts. "Bankruptcy."
- United States Courts. "Bankruptcy Basics Glossary."
- Forbes. 2020. "Bankruptcy Is Not The End."