Insolvency occurs when a company or individual has insufficient funds to pay their essential bills and other costs, such as debt repayments. This leads to the company’s liabilities eclipsing the value of its assets and normal operations being unable to continue.
Being insolvent does not necessarily mean that a company goes out of business. However, it may result in further measures such as administration or liquidation if the debtor is unable to come to an arrangement with the creditor. Debtors and creditors will often work together to restore operating cash flow to the business so that it is able to maintain operations and eventually satisfy its creditors.
How insolvency works
When a company becomes insolvent, it will usually have an opportunity to arrange an informal agreement before legal insolvency proceedings begin. This will usually involve restructuring the debt or taking out a debt consolidation loan. This is usually in a creditor’s best interest, as even though it extends the terms of the debt, it prevents losses and delays from lengthy court proceedings.
If, however, either the debtor or creditor is unwilling to pursue an informal agreement, the courts will intervene and appoint an insolvency practitioner to find a resolution that satisfies all creditors and keeps the business operational where possible.
Common causes of insolvency
When a company becomes insolvent, there is rarely one single cause. Rather, there are a host of contributing factors that gradually erode a company or individual’s solvency. These typically include:
Poor budgeting or financial management
Wasteful spending or operational over-spending
Excessive borrowing leading to more debts
Lack of customer retention
Rising vendor costs
Options for an insolvent company
An insolvent company needn’t be a bankrupt company. There are several options an insolvent company may pursue with its creditors and the UK government has published guidance for each. Many of these options will allow the company to continue operating and improve its financial prospects.
An informal agreement is an arrangement that allows a debtor to renegotiate the terms of their debt so that it is more favourable to company operations. For example, they may extend the term of the debt in order to reduce monthly repayments.
Company voluntary agreement (CVA)
If a creditor requires a more legally-binding arrangement in the event of insolvency, this is known as a company voluntary arrangement (CVA).
When pursuing a CVA, the debtor will present creditors with an achievable plan for repaying outstanding debts and costs. A CVA must be approved by at least 75% (by value) of a company’s creditors.
If a company goes into administration, an insolvency practitioner (an administrator) is appointed to take charge of operations and draws up plans to restore the company’s viability, realise enough assets to satisfy creditors or, as a last resort, sell the company as a going concern.
Creditors cannot take steps to recover their debts during this process.
Receivership is when an administrator is appointed by a holder, usually a bank, to recover payments on behalf of secured creditors.
If the company cannot maintain operations, a ‘winding up’ petition may be made to the court by either the creditor or the company. The court then issues a winding-up order and a liquidator is appointed to begin liquidation proceedings. The company’s assets are then either sold or distributed among creditors and whatever is left over is divided among shareholders.
What is the difference between insolvency and bankruptcy?
Insolvency and bankruptcy are often used interchangeably. However, while insolvency is the financial state of being unable to repay debts or costs, bankruptcy is the legal process of discharging those debts and satisfying creditors as much as possible.
What is the difference between liquidation and administration?
When a company goes into administration, an insolvency professional will take over business operations in order to rectify the company’s finances and satisfy creditors. Liquidation involves winding up the company and liquidating its assets to satisfy creditors.
How can a business avoid insolvency?
The best way for a business to avoid insolvency is through sound budgeting and wise financial management. Finding ways to boost revenue instead of relying on borrowing to fund growth can also help companies remain solvent.