Insolvency – Definition

Cite this article as:"Insolvency – Definition," in The Business Professor, updated October 15, 2019, last accessed October 27, 2020,


Insolvency Definition

Insolvency refers to a term for when an organization or individual can’t meet its financial duties with its lender or lenders as debts become due. Before an insolvent individual or company engages in insolvency proceedings, it would probably get involved in informal arrangements with creditors, like making new payment arrangements. Insolvency is capable of springing from poor cash management, increased expenses, or reduced cash inflow forecasts.

A Little More on What is Insolvency

Insolvency refers to a financially distressed state whereby an individual cannot afford to pay their bills. It can result in insolvency proceedings, where legal action would be used against the insolvent party, and there may be a liquidation of assets to pay outstanding debts. Numerous factors exist which can contribute to the insolvency of a person or company.

Insolvency vs Bankruptcy

Contrary to the majority’s beliefs, insolvency and bankruptcy aren’t the same. Insolvency is a financial distress type, implying a person or entity’s financial state of being unable to settle the bills or other obligations. The Internal Revenue Service (IRS) stipulates that an individual is insolvent when all the liabilities surpass the total assets. But bankruptcy is a real court order which reflects precisely how an insolvent business or individual would pay off his creditors, or ways he would sell his assets for making payments.

Thus, an individual or corporation is capable of being insolvent without experiencing bankruptcy, even if it is temporary. Supposing this spans longer than expected, then it can result in bankruptcy.

Factors Leading to Insolvency

When a company hires inadequate accounting or human resources management, it might add to insolvency. For instance, the accounting manager might create or follow the budget of the company improperly, thus, resulting in overspending. Expenses accumulate swiftly when excess money flows out and insufficient of it is entering the business.

Rising vendor costs might also contribute to insolvency. In a situation where a business must pay a higher amount for goods and services contributing majorly to their offerings, the company transfers the cost to the consumer. Instead of paying the higher cost, the majority of consumers change to a new place where they would pay less for products or services. Losing clients bring about the loss of income for paying the creditors of the company.

Customers’ lawsuits or those of business associates might push a company into insolvency. The business might eventually pay huge sums of money in damages thus, making it impossible for it to continue functioning. When operations stop, so does the revenue of the company. Lack of revenue brings about unpaid bills, as well as, creditors seeking the money they’re owed.

Certain companies become insolvent solely because their offerings don’t arise to soothe the changing needs of consumers. When consumers start business activities with other companies that offer larger product and service selections, the company would lose profits if it doesn’t adapt to the marketplace. Expenses surpass income while bills remain unpaid.

Negotiating With Creditors

Business owners might call creditors directly and reshape debts into better managed installments. Creditors are usually approving to this approach because they are aware that cash flow problems begin with businesses and they seek repayment.

Business Debt Restructuring

Supposing a business owner intends to restructure the company’s debt, he comes up with a practicable plan showing ways in which he can lessen company overhead and keep on executing business operations. The owner creates a proposal stating how the debt might be reorganized utilizing the cost reduction or other support plans. The proposal portrays to creditors how the business might produce adequate cash flow for favorable operations while repaying its debts.

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