It is a situation in which a business fails to pay back its debt obligations

Author: Alvin Dookhony
Alvin Dookhony
Alvin Dookhony
Reviewed By: Michael Rahme
Michael Rahme
Michael Rahme
Last Updated:March 6, 2024

What Is Insolvency?

Insolvency is a situation in which a business fails to pay back its debt obligations. It can also be seen as bankruptcy for a company.

We can classify a company as insolvent when its liabilities exceed its assets or when it cannot meet its outgoings whenever they fall due.

Even if the latter presents a dangerous situation for a company, it does not necessarily mean it is beyond rescue. On the contrary, the available business options could still reverse the company's position and put it back on track for financial success.

The latter can also be applied to a person whereby the latter is not able to pay back his long-term loan to the bank.

When a business is declared insolvent, it must take the necessary steps to prevent further depreciation of its assets and cash depletion. 

Here, the expertise of an insolvency practitioner helps determine the steps to take to assist the business in return to a solvent state.

Key Takeaways

  • Insolvency occurs when a business cannot meet its debt obligations, either because its liabilities exceed its assets or it can't pay its bills on time.
  • Two main tests are used to determine insolvency: the cash flow test, which assesses the ability to meet financial obligations when they're due, and the balance sheet test, which compares assets to liabilities.
  • Poor long-term cash flow planning, excessive borrowing, dependence on key staff, and unreliable business strategies can contribute to insolvency.
  • Implementing credit control procedures, regularly reviewing credit limits, exploring credit insurance or invoice financing, and finding ways to reduce business expenses can help mitigate the risk of insolvency.

How Insolvency Works

When a business is declared insolvent, the first steps to follow include doing what's necessary to prevent further depreciation of assets and depletion of cash. But, of course, the end goal of managing it is ensuring that as much money is given back to investors and creditors.

In a situation whereby it is possible to bring a company back from an insolvent state, the expertise of an insolvency practitioner is deemed necessary. The latter can determine what steps to take to return the company to a solvent state.

In the above process, shareholders and directors can request the following out of court:

  • Liquidation: this implies the complete liquidation of all assets and cash accounts.
  • Administration: This involves restructuring a business in an attempt to save it.
  • Receivership: A creditor, such as a bank or other investor, appoints an insolvency practitioner to manage the assets to meet as many debt obligations as possible.
  • Company voluntary arrangement: where a contract is drawn up regarding the payment of debt following an agreement made between the company and its creditors

Detecting Insolvency

There are two main tests that a business owner can take to determine whether his company is insolvent.

1. Cash flow test

The following evaluates the ability of a company to meet its financial obligations whenever they fall due. It aims at answering questions such as "can you pay your bills on time and in full?" A negative answer to the above question indicates that a company is insolvent.

2. Balance sheet test

The balance sheet test analyzes all the assets of a company, such as property, machinery, and stock, and weighs these against the company's current and prospective liabilities( debts). We can classify the company as insolvent when the liabilities outweigh the assets.

While these tests can prove whether a company is technically insolvent or not, other warning signs should be considered, which can mean that the company is at risk of becoming insolvent. Some signs of taking into account are as follows,

  • The business is having difficulty keeping track of its financial obligations and is frequently making late or partial payments to its creditors.
  • The company lacks the cash flow needed to account for basic operating expenses.
  • The business has been borrowing the maximum allowed amount from the bank/ suppliers, referred to as ceiling borrowing.
  • Directors of the company are not being paid due to insufficient funds.

Factors Contributing to Insolvency

Business insolvency can involve many factors, but the common elements are always present. Factors can range from Capital management, cash flow, and business decisions.

1. Poor planning decisions for long-term cash flow

Abnormally high expenditure while pursuing business expansion and throwing money at business development can have dire consequences for a company. This can lead to a cash flow crisis due to limited funds.

Preparing for any potential financial issue that could impact the business requires a contingency budget. It's advisable to keep enough cash in your company's account to cover its expenses and liabilities, even if such a move might mean slowing down its growth rate.

2. Excessive borrowing to fuel business growth

Constrained credit situations resulting in borrowing money based on future revenue are a common reason. This situation even applies to good businesses. A business that tends to borrow excessively places itself in a risky situation.

An event whereby its sales drop significantly can put the business in a situation where it cannot fulfill its debt obligations due to a decline in revenue.

It's essential to minimize a business's unnecessary debt, especially in its early growth stage. Excessive debt results in unwanted situations that can place a company in an insolvent position if its cash flow reaches a standstill.

3. Loss of a staff member integral to business success

High dependence on a single employee or a lack of delegation to the second line of management can lead to the failure of a business. In addition, any company exposes itself to being in a state of insolvency if a critical member resigns from the company or passes away, as its absence creates a vacuum that can be hard to replace.

It's also essential to mitigate the effects of losing a key staff member by ensuring the business isn't overly dependent on one person. Ensure that other members of the organization are equipped with the essential training to take over in the event of a sudden departure

4. Risky, unreliable business strategy, investments, and competition

Numerous businesses underestimate their competitors and hence fall short of business strategy and long-term investment, leading to business failure. Ignoring competitors, significantly when they're growing rapidly, can lead to a business losing its market share.

As a result, it can lead to falling profits and a lack of cash to operate the business effectively. Therefore, it is advisable to prepare ahead of time to avoid losing market share to a competitor. Consequently, studying the business competitors and understanding their value proposition and benefits is recommended.

Once the above is well in place, we must ensure that our business can offer better quality products and services than them to capture a larger market share, hence higher profits.

remedies for Insolvency

There are numerous strategies available to help such a company. 

It is paramount to understand the factors surrounding the business, which might include the level of distress a company is under, its future viability, and the desire on behalf of its directors to turn the situation around.

Some of the remedies are:

1. Informal Creditors Arrangement or Time to Pay ( TTP)

Before attempting a formal process, it is an excellent move to negotiate with creditors to reach a manageable repayment term for outstanding debts. 

This process can keep creditors satisfied, eventually preventing legal actions from being taken on their behalf.

If the company's liabilities are mainly owed to HMRC, it might receive a TTP arrangement. This objective is to give the organization enough time to bring its account with HMRC up to date.

2. Administration

Once a company enters administration, the latter is given a moratorium which prevents any legal actions from being launched by creditors, thereby allowing the company to be rescued from liquidation.

The administration also gives a company a temporary solution in the time and space required to devise a plan of action against its creditors.

Following administration, a company may be sold to a connected or unconnected buyer, restructured and continue to operate under the current owners, or even enter an alternative process such as a CVA or liquidation.

3. Refinancing Options

If a business faces irregular cash flow or needs cash injection to boost its operations, taking out a form of commercial finance could be a viable solution. Valuable assets of the business can be used as collateral to obtain a record of secured financing.

4. Liquidation

If the company's issues have brought it beyond the point of rescue, placing the company into liquidation is considered the most appropriate option. 

The company directors can achieve a liquidation through a process known as a Creditor's Voluntary Liquidation ( CVL). 

During the process, an appointed insolvency practitioner will identify all company assets before these are valued and sold, with the proceeds distributed to creditors. 

Following this, the company will be removed from the registrar-held companies House and cease to exist as a legal entity.

limiting the risks of insolvency

To protect a company and mitigate its risk of turning into the above situation, we can take the following measures:

1. Implement credit control procedures

 A business should set a clear and effective credit control procedure that it follows every time an account becomes overdue. This will make space for identifying any risks at an early stage and acting accordingly.

2. Regularly review credit limits.

Companies regularly extend their credit terms to attract new business partnerships and develop good customer relationships. It is hence essential to monitor this carefully and set a credit limit.

3. Explore credit insurance and invoice financing

credit insurance policy will pay out and shield a company against customers who fail to pay. Alternatively, an invoice financing agreement can be used, such as non-recourse factoring, which pays a proportion of the value of an invoice upfront.

Other ways to limit the risks o\ include finding intelligent ways to reduce business expenses which are listed below:

  • Lease rather than buy business equipment
  • Embrace technology and automation
  • Implement a strict business budget
  • Push your suppliers for the most competitive pricing deals or shop around
  • Minimize inefficiency
  • Adopt teleconferencing as an alternative to expensive corporate travel

Insolvency FAQs

Researched and authored by Alvin Dookhony | LinkedIn

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