Most people use terms like “insolvency” and “bankruptcy” interchangeably thinking that it is the same thing. These terms are similar but in no way identical as they have two different meanings. This difference is important to understand as it could lead to very different business outcomes. To start off, insolvency is a state of financial being. It is reached when we are unable to pay off our debts in time. On the other hand, bankruptcy is a legal process that resolves the issue of insolvency. Of course, there is a lot more that goes into these definitions and it varies from country to country, jurisdiction to jurisdiction. Let’s go over all the concepts needed to learn in order to fully comprehend the implications a bankruptcy and insolvency can have.
First of all, we will go over the deeper meanings of the two terms. Insolvency is the state that could prompt one to file for bankruptcy. Anyone, a single person, a family or an entire company can become insolvent when they cannot pay its lenders back on time. This state usually appears when the cash flow that comes in is lower than the cash going out for a longer period of time. For individuals, it means that their monthly income is lower than their monthly financial obligations. And for companies, it means that the cash flow the business generates combined with the assets it owns is less valuable than its liabilities. Insolvency is the state or step before bankruptcy. Usually, people or companies that become insolvent can take certain steps towards a constructive solution. One of those solutions, though not necessarily a constructive one, is bankruptcy.
Bankruptcy is a legal term. It is a legally binding declaration on an inability to pay off debts. When an entity, be it an individual or a business, files for bankruptcy, the obligation of paying off debts is not waived off. Instead, said entity binds itself to pay off what is owed but with government aid. Generally speaking, there are two forms of bankruptcy, reorganization, and liquidation. The first one restructures the debtor’s repayment plans to make them easier to meet. The latter forces debtors to sell assets (liquidate them) in order to pay the necessary amounts to creditors. These definitions are condensed in a nutshell. For any further information, it is highly advisable to contact reputable insolvency services in Sydney as it can get quite technical and is very legally sensitive.
3. Balance sheet
Businesses use a balance sheet insolvency test to decide the dilemma of trying to stay afloat or filing for bankruptcy. There are 3 factors that a business needs to consider in order to make a decision. The inflows, outflow, and assets all play a vital role and their balance can determine the next course of action. A negative net asset is a situation when the inflows are less than outflows and the value of the assets is worth less than what is owed. Usually, it means that some sort of external aid is necessary in order to meet all the financial obligations. On the other hand, if the company can sell some of the assets, it might attempt to cover the debts on its own. It does mean reducing the business operation overall and could entail an inability to continue working in the future. It is not a very efficient way of going on about it. Financial advisors will conduct all the necessary reviews and make suggestion scenarios for reducing or outright eliminating debt. Creditors can be convinced that future cash flows will facilitate more room to breathe, financially speaking, in the future. But in that case, be ready to give one hell of a presentation.
4. Cash flow
An entity is cash flow insolvent when it is unable to meet its financial obligations solely based on the lack of money. Not to be mistaken with foreseeing a more restrictive financial period in the future. Cash flow insolvency only ensues when we are not able to keep the lights on and pay other bills. Financial troubles and constraints are an everyday occurrence and do not fall under this category. Cash flow insolvency affects all entities as well, individuals, families, and businesses. Deciding on a further course of action is to take a cash-flow test. The debtor needs to evaluate current and future cash flows to determine if the projected income would be enough to cover all the expenses. This analysis will help us decide whether to push for a debt settlement or go and file for bankruptcy.
Economical and legal terms such as these can get confusing and have a lot more going on behind the curtains. Now that we have a firmer grasp of what they constitute, we can make healthier and constructive decisions for the future.