Insolvency is the state that a company or individual enters when they are not able to pay their debts.When a business becomes insolvent, this means that their debts (liabilities) are greater than the value of their assets and income. In effect, they are not able to pay back money owed, either currently or in the future.
It is possible for a company to be insolvent even if its assets outweigh its liabilities if the assets are not easily converted to cash needed in order for the company to make the necessary payments.
When a person becomes insolvent, this is generally known as ‘bankruptcy’ and falls under an entirely different set of rules and necessary procedures.
How a company becomes insolvent?
There are many ways that a company can find itself in the unfortunate situation of insolvency. However, there are a few common causes:
- The business has not adjusted to keep up with the current market
- Overly ambitious growth plans that deplete the company’s financial resources
- Improper or unqualified management
- Lack of thorough bookkeeping
- There are two tests that will generally reveal whether a company has become (or is at risk of becoming) insolvent.
Balance sheet test
Under the balance sheet test, a thorough overview of the company’s balance sheet should reveal whether the liabilities are larger than the assets either now or in the future, taking into account both expected and unexpected expenses.
Cash flow test
This test involves analyzing the company’s budget to determine whether there is enough cash or convertible assets to pay off the current and upcoming debts. When a business betrays one or both of these tests, it is likely already experiencing or heading about insolvency and should follow the necessary procedure.
The insolvency process
Once a business is proclaimed insolvent, it’s necessary that it does what is obligatory to prevent further depreciation of assets and depletion of cash. The windup aim of controlling insolvency is to certify that as much money is returned to investors and creditors as possible.
In some hearing, it might be manageable to bring the company back from insolvency. In this condition, the expertise of an insolvency practitioner is mandatory like CDPB practitioner.
In insolvency, the shareholders and directors can request the following out of court:
- Liquidation of the business which means the complete liquidation of all assets and cash accounts.
- Administration, which involves the restructuring of the business in an attempt to save it.
- Insolvency, wherein a creditor or creditors, such as a bank or other investor, appoints an insolvency practitioner to control the assets in order to pay off the debt as much as possible.
- Company voluntary arrangement, where a contract is drawn up regarding the payment of a debt after an agreement is made between the company and the creditors.
Thus the best mode to hold off insolvency is to create realistic budgets, keep track of the finances of your business, and stay abreast of the market in which your company is operating.