What Is Insolvency?
Insolvency is the inability of a debtor to pay their debt. Cash flow insolvency involves a lack of liquidity to pay debts as they fall due. Balance sheet insolvency involves having negative net assets—where liabilities exceed assets. Insolvency is not a synonym for bankruptcy, which is a determination of insolvency made by a court of law with resulting legal orders intended to resolve the insolvency.
A business may be cash-flow insolvent but balance-sheet solvent if it holds illiquid assets, particularly against short term debt that it cannot immediately realize if called upon to do so. Conversely, a business can have negative net assets showing on its balance sheet but still be cash-flow solvent if ongoing revenue is able to meet debt obligations, and thus avoid default: for instance, if it holds long term debt. Many large companies operate permanently in this state.
Insolvency is defined both in terms of cash flow and in terms of balance sheet in the UK Insolvency Act 1986, Section 123, which reads in part:
- 123. Definition of inability to pay debts
- (1) A company is deemed unable to pay its debts –
- (e) if it is proved to the satisfaction of the court that the company is unable to pay its debts as they fall due. This is known as cash flow insolvency.
- (2) A company is also deemed unable to pay its debts if it is proved to the satisfaction of the court that the value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities. This is known as balance sheet insolvency.
Consequences Of Insolvency
The principal focus of modern insolvency legislation and business debt restructuring practices no longer rests on the liquidation and elimination of insolvent entities but on the remodeling of the financial and organizational structure of debtors experiencing financial distress so as to permit the rehabilitation and continuation of their business. This is known as Business Turnaround or Business Recovery. Owners of businesses that had at any stage traded insolvently (i.e. that had a balance-sheet insolvency) become personally liable for the business’ debts. Trading insolvently is often regarded as normal business practice in South Africa, as long as the business is able to fulfill its debt obligations when they fall due.