What is insolvency?

Here is everything you need to know about insolvency. We take a look at what causes it, how it differs from bankruptcy and what it means for your business.

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

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What is insolvency? What does it mean to be insolvent? And how does insolvency differ from bankruptcy?

If you’ve ever found yourself pondering these questions, then this article is for you. We’ll tell you everything you need to know about insolvency and the consequences it could have for you and your business.

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What is insolvency?

To put it in the most basic terms, insolvency refers to a financial state in which an individual or a company can no longer pay their debts and other obligations on time.

It arises whenever your liabilities or debts exceed your assets and cash flow.

How does insolvency differ from bankruptcy?

Insolvency is commonly confused with bankruptcy. But there are significant differences between the two concepts. 

  • Insolvency basically occurs when a company or an individual’s liabilities exceed their assets.
  • Bankruptcy, on the other hand, is a legal process in which a court declares that an individual is insolvent and unable to repay their debts.
  • A business or person may be insolvent without necessarily being bankrupt.

While insolvency can lead to bankruptcy, it can also be a temporary situation that can be resolved or fixed without the need for legal protection from creditors.

How can you tell whether you or your company is insolvent?

Two simple tests will show whether you or your company are insolvent:

1. Cash flow test

The cash flow test is all about whether you or your company can actually pay debts as they fall due. It’s quite simple: if you can’t pay debts as they fall due, then there’s a good chance that you are insolvent.

2. Balance sheet test

The balance sheet test attempts to answer the following question: Do you or your company owe more in liabilities than the reasonable market value of your assets? If it is determined that liabilities exceed assets, then you or your company are considered technically insolvent.

It is important to note that an insolvency verdict does not mean the end of your business. For example, even if your company fails one of the insolvency tests, it may still be able to trade its way out of trouble and return to solvency.

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What does insolvency mean for you or your business?

Individual: Being insolvent could lead to you being declared bankrupt.

Company: If your company is insolvent, you stand the risk of having a winding-up petition issued against it. This could lead to the courts ordering your company into compulsory liquidation whereby your assets are sold to repay creditors.

Once you’ve determined that you or your company are insolvent, it’s vital that you act fast. Your first course of action should be to seek the services of a licensed insolvency practitioner.

They can walk you through your options and help you decide on the best next steps.

What are the available options after insolvency?

Individual

For individuals, one option is to declare bankruptcy. This might be suitable if you owe more than £5,000 to any creditor and you’re sure that you have no way of repaying it.

But if you don’t want to go down the bankruptcy route, then consider a debt relief order (DRO) or an individual voluntary arrangement (IVA).

Company

There are numerous options here.

Informal Creditors Arrangement or Time to Pay. This involves an informal negotiation with creditors to come to some agreement on how you will pay back what you owe. If the majority of your obligations are to HMRC, you may be able to obtain a Time To Pay arrangement.

Compulsory Voluntary Arrangement (CVA). A CVA is essentially a legally binding agreement between your company and your creditors that establishes a formal payment plan.

Administration. You can apply to have your company placed into administration, which protects you from legal action from creditors while an insolvency practitioner restructures the company with the goal of returning it to profitability.

Obtain alternative finance. A cash injection may be all that is needed to boost operations. You could borrow money using existing lines of credit, or even sell off some of your assets.

Initiate a voluntary liquidation. This can give you more control over the outcome than, say, a compulsory liquidation initiated by creditors.

Final word

Insolvency does not necessarily mean the end for you or your company. You can still turn things around, but you need to act fast. A good place to start is seeking legal counsel and advice to determine all of your options.

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