InsolvencyDefinition and What Is It and What Causes It?

Written By:
Adiste Mae

As a business owner, generating profits should not be your only goal.

You should also think about whether you have enough to pay your creditors when your debts become due.

Since your creditors were kind enough to lend you money when you needed it, it’s only common courtesy to pay them back on time.

Of course, do not forget your service providers too.

Make sure that you can pay them on time to build a good reputation with them.

But if you just don’t have enough to pay your bills and debts, then you might already be at the onset of insolvency.

Or even worse, you and your business may already be insolvent.

What is Insolvency?

Insolvency is a state of financial inadequacy. It can happen to an individual or a business entity.

Insolvency is a state in which an individual or business entity no longer has the capability to meet his/her/its financial obligations such as debts and bills as they become due.

Or it could also be that the liabilities exceed the assets.

Insolvency does not necessarily mean the end of a business though.

You can still turn the situation around, but you need to be swift and decisive about it.

Insolvency can be temporary, and the shorter the time you spend being insolvent, the better.

You might want to consider professional intervention to improve your chances of making a comeback.

What causes insolvency?

There’s no need to sugarcoat it.

The main cause of insolvency is poor financial management.

Although, there can also be multiple reasons as to why it happens: loss of capital, loss of revenue, loss of cash inflow, loss of credit – all of which stem from poor financial management.

And even though a lot of businesses are aware of these issues, they often fail to address them properly.

As the problem drags on, things spiral out of control, and they will one day find themselves on the brink of insolvency.

Or it could be that they are already insolvent and that they weren’t aware of it.

Lack of proper financial planning or cash flow planning

It’s easy to lose track of your business’s spending when you’re doing it for the development of your business.

Limited funds and lack of proper cash flow planning – the combination of these two often leads to a cash flow crisis (which can also lead to insolvency).

To remedy this, you must have a proper cash flow plan for your business.

Always keep enough cash to cover expenses and liabilities (be they expected or unexpected).

And yes, do so even if you have to slow down your business’s growth rate.

Prioritize having a stable cash flow first. Having a “slow but steadily growing’ business is safer than having a “fast-growing but always on the brink of insolvency” one.

Speaking of business growth…

Fueling business growth with excessive borrowing

It’s always exciting to see your business grow, especially if you are the one driving it.

Growth can lead to more profits too right?

But if you get too excited to the point where you borrow an excessive amount of money to fuel business growth, let’s just say that it might go back to the main cause of insolvency – poor financial management.

Basing borrowings on future revenue is a typical reason why businesses become insolvent.

Sure, it’s okay if you realize your projected revenue.

But you can’t deny that it puts you in a risky position.

Even more so if you borrow excessively.

Even just a single period of low sales can lead to failure.

Not to mention that with excessive borrowings comes excessive interest.

If your business is still in its early stages, you might want to keep your borrowings to a minimum.

As much as possible, only borrow what is necessary.

That’s not to say though that you can excessively borrow if your business is already in a stable state.

Even if your business is doing well, it can all go down due to poor financial management.

Having excessive debt puts you in a vulnerable position.

If you fail to pay even one installment, things might spiral out of control, and then you’d find yourself on the brink of insolvency.

Over-dependence on one particular customer

Having a loyal customer that always supports your business is a great thing to have.

Even better if you have a lot of them.

But if your business is overly dependent on one specific customer or client, what if one day they stop supporting your business?

Or what if they decide to switch to another business?

Or what if they fail to pay the money they owe you?

Being over-reliant on one customer comes with a more pronounced risk of failure.

If that customer decides to no longer support your business, then you’d lose a significant chunk of your revenue and might even result in insolvency.

Likewise, if the customer becomes insolvent themselves, then they are unlikely to pay you which, again, may lead to insolvency.

Aim to have a lot of loyal customers instead of just one.

That way, you won’t have to carry the risk of insolvency due to over-dependence on a single customer.

Speaking of your customer switching to another business…

Grossly underestimating the competition

Being confident in your business is good.

Being overconfident is not.

Another reason why businesses fail is that they underestimate their competition.

Add to that not having a business strategy and growth plan to address competition.

Let’s take a look at the once-popular Blackberry phone.

Blackberry phones were the go-to choice of business people.

When Apple emerged with its smartphone (the iPhone), Blackberry shrugged it off and just kept doing what they’re doing.

But then Apple didn’t stop innovating and eventually dominated the phone market.

Nowadays, you’ll rarely find someone sporting a Blackberry.

You’re more likely to find someone who owns an iPhone.

Always have a business plan to address the competition.

Not having one can lead to losing your business’s market share, which will then lead to fewer profits, and most probably a decline in cash inflow.

This all can ultimately lead to the inability to pay your financial obligations a.k.a insolvency.

Lack of knowledge in running your business

Let me just put this on the table: everyone is allowed to run a business, but that doesn’t mean that you can just haphazardly form a business.

Not having the minimal know-how in running a business is just like throwing away your money for no reason.

You need to be extremely lucky to run a successful business like that.

And even if it did run successfully, if you still lack the knowledge to run it well, it will eventually go back to the main cause of insolvency – poor financial management.

There’s a sort of workaround on this – hire competent employees to manage the business for you.

But that also comes with a risk.

So even if you can hire a very capable employee, it won’t hurt to know about your business.

It is your business after all.

Over-reliance on one staff member who’s integral to business success

So I previously mentioned that there is a risk to hiring and/or relying on competent employees.

It’s more pronounced when you’re over-relying on one employee.

If that employee suddenly leaves, what then?

This is similar to the “over-dependence on a single customer” situation.

Over-reliance on a single employee comes with the risk of insolvency.

To remedy this, make sure that you’re prepared in a situation where you might lose an important employee.

If you’re hiring a lot of employees, it’s a good idea to train some of them, just enough so that they can take over if ever the need arises (e.g. an important employee resigns, will be on leave for a long time, etc.).

Don’t get too complacent even if your business is doing very well.

The possibility of insolvency is always there, especially if there is a lack of proper financial planning.

It is in your best interest to keep the risk of insolvency as low as possible.

Having an understanding of the most common causes of insolvency will equip you with the knowledge to protect your business (and yourself) from the risk of insolvency.

Is Bankruptcy the same as Insolvency?

Short answer: No. They are not the same.

Although the two terms are used interchangeably, insolvency and bankruptcy are actually not one and same.

Insolvency is a state of financial distress.

Bankruptcy is a legal status to be determined and declared by a judicial decree. So no, they’re not the same.

Bankruptcy is always preceded by insolvency, but insolvency doesn’t always necessarily lead to bankruptcy.

That means that a business can be insolvent without being bankrupt.

However, the reverse cannot be true.

Before a business can declare bankruptcy, it needs to prove that it cannot pay for all of its financial obligations with its assets (which is insolvency).

Although insolvency is an essential factor of bankruptcy, it does not mean that it’s the only ingredient.

There are additional requirements before an individual or business can declare bankruptcy, such as filing for bankruptcy.

The Two Types of Insolvency

In business (though it can apply to individuals too), there are two types of insolvency:

1. Cash-flow insolvency
2. Balance sheet insolvency.

Cash-flow insolvency

If a business has enough assets to pay off its creditors, but is not liquid enough or does not have the cash to pay for debts, bills, and other payables, then this type of insolvency occurs.

If the business decides to sell all of its assets, it may have enough to satisfy all of its debts.

In short, cash-flow insolvency is more of a lack of liquidity rather than being truly insolvent.

Being cash-flow insolvent is easier to recover from than the other type of insolvency.

It can be remedied by negotiating with your creditors.

You can ask your creditor for a longer-term, or wait a little further for the next installment (or two).

This will give you enough time to gather enough cash to pay off the debt which can be done by generating more cash sales or converting some non-cash liquid assets into cash.

It won’t be a one-sided arrangement though. In exchange for the extended due date, your creditor might require you to pay a penalty on top of the principal and interest payments, but that’s better than having to go through insolvency proceedings.

To test for cash-flow insolvency, ask yourself this question: “Can my business pay its bills and debts on time?”.

If your answer is no, then your business is probably experiencing cash-flow insolvency.

Balance-sheet insolvency

If a business does not have enough assets to satisfy all of its financial liabilities, then this type of insolvency occurs.

Unlike cash-flow insolvency that is more so temporary, balance-sheet insolvency is more prone to being permanent and thus will probably lead to bankruptcy.

Balance-sheet insolvency is also referred to as technical insolvency.

To test for balance-sheet insolvency, ask yourself either of these questions:

“Can my business pay for all of its liabilities if I sell all of its assets?” or “Does my business have more assets than liabilities?”.

If your answer is no to either question, then your business is experiencing balance-sheet insolvency.

Another way to test for business insolvency is to divide your business’s total assets over total liabilities.

If the resulting figure is less than 1, then your business is experiencing balance-sheet insolvency.

Signs of Insolvency

If your business is undergoing any of the following, then your business might be insolvent or is about to become one:

• Constantly late in making bills and debt payments
• Using debt to pay off other debts
• Is delayed in paying the salaries and wages of employees
• Only has the minimum cash balance in banks
• Have to sell off some non-cash assets to pay obligations
• Lots of bad debt; unable to collect a majority of accounts receivable
• Loans are at the maximum credit limit
• Loss of loyal suppliers and service providers
• High employee turnover rate
• Always receiving urgent notices of payment from creditors

There might be other signs of insolvency not included in the list above.

The main indicator is that if your business no longer has the capacity to pay its financial obligations on time, then it may already be experiencing insolvency.

Insolvency proceedings

If you or your business can longer negotiate with your creditors regarding your debts, then you may need to proceed with insolvency proceedings.

It is a process that is taken with a business or individual can no longer pay for its financial obligations.

The goal of an insolvency proceeding is to provide maximum return to creditors (and to an extent, equity holders).