Insolvency is the inability to pay ones debts. Both companies and people can be deemed insolvent. There are two different ways in which insolvency can be defined and they are:
- Cash flow insolvency – the inability to pay you debts when they are due
- Balance sheet insolvency – when your liabilities are greater than your assets
It is possible for companies to perform under one of these conditions, but have no problem with the other. It is not unusual that a company has assets greater than its liabilities, but doesn’t have the cash flow to pay its debts on time. This occurs especially when dealing with short-term debt in companies that have large quantities of illiquid assets. Also, it is possible that a company is “balance sheet insolvent”, but it still has a large enough cash flow to pay its debts when they are due. In fact, for some businesses this is the constant state of operation.
Being insolvent is a problem for both the company and its creditors. It is usually dealt with through debt restructuring, loans (if the problem is realistically, very short-term) and, in severe cases, bankruptcy.