Insolvency is defined as the inability to pay debts. It is a state of financial distress in which an individual or a company is being unable to meet financial obligations and the person who is in the state of insolvency is called insolvent. Insolvency can arise due to poor cash management, unavailability of alternative payment arrangements, or an increase in expenses. Insolvency takes two forms: cash-flow insolvency and balance sheet insolvency. Hire the best lawyer in India.
Bankruptcy comes up with a solution for insolvency. It is defined as a legal process which helps insolvents to get relieved from their debts. Bankruptcy is a legal proceeding in which a judge and court trustee examines the assets and liabilities of the individual and entity who are not in a position to pay their debts.
Insolvency is not a synonym for bankruptcy. Insolvency is a state of being insolvent whereas bankruptcy is a legal process. Insolvency in a company may arise due to various reasons and results in poor cash flow. A company can contact their creditors directly when they face insolvency and restructure their debts into manageable installments. They can also request to extend the due date and sell their asset to meet the financial obligations of their debts before it falls due. Insolvency can be classified into two: cash-flow insolvency and balance sheet insolvency.
1. Cash-flow insolvency
This type of insolvency arises when a person lacks the appropriate payment method to pay for his debts but has enough assets. For example, a person may have a big house, lands, and a car, but does not have enough liquid assets to pay for what is owed when it falls due. When an individual or an entity cannot pay a debt to creditors because they don’t have money, then they are called cash-flow insolvent. In short, the debtor may have tangible assets but lack cash on hand to pay the debts.
Cash-flow insolvency affects both businesses and individuals. Such insolvency can sometimes be solved by negotiation. This is possible only if the creditor is willing to wait for the repayment by giving the debtor a reasonable amount of time to sell his tangible properties. Even the debtor may agree to pay an additional amount in penalty along with the principal amount and interest owed.
2. Balance sheet insolvency
Balance sheet insolvency is when a person or a firm does not have enough assets to pay all their debts. To resolve the situation, the person or company may either enter bankruptcy or sometimes negotiation with the creditor may resolve the situation. It also arises when the total liabilities of the company exceed the total assets or when the contingent liabilities outweigh the total assets. Contingent liabilities are liabilities that may occur in the future depending on the outcome of an uncertain future event.
The word bankruptcy is derived from an Italian word Bancarotta which literally means “broken bench” or “broken bank”. Bankruptcy is a legal process through which an individual or a company that is not in a position to repay debts to creditors may seek relief from some or all of their debts. Most commonly, the legal proceedings begin with filing a petition by the debtor or on behalf of creditors, which is less common. The debtor’s assets are calculated and validated, and the assets may be used to repay a part of their debts. Filing bankruptcy may help you to overcome your current financial distress but you may find it difficult when you apply for a loan to start a fresh business.
The principal focus of bankruptcy is to remodel the financial and organizational structure of debtors who are experiencing financial distress and to permit the rehabilitation and continuation of the business. The legal proceeding of bankruptcy is different in different countries. Mostly bankruptcy is imposed by a court order which is often initiated by the debtor. The debtor can thus put an end to debt and free himself from debt obligations by filing bankruptcy.
Final Thoughts Though insolvency and bankruptcy are similar but have different meanings. Insolvency is the state of being in financial distress that prompts one to file a bankruptcy. If you are insolvent and believe in bankruptcy then overcome your financial distress now by filing bankruptcy.