Definition of Insolvency

Insolvency can be defined as a situation when the company or an individual is unable to meet his / their financial obligation due to insufficient cash flow. It is also referred to as a state where the assets of an individual/company are not enough to settle for their liabilities. If insolvency is not treated on time, then it can become bankrupt. Therefore, the individual/company should take the necessary steps to rectify the insolvency; otherwise, it will become bankrupt.

Example of Insolvency

Bata co. Ltd has branches all over the US. One of its branches has taken a loan that was due on the 5^th of this month, but due to some cash flow crunch, the debt payment could not be processed even though the assets of the company were more than its liabilities. Now, if this situation persists, then the company will be known as insolvent.

Kingston and company manufacture shoes in the U.S. They have 3 big dealers who used to buy shoes from them and sell them in the market. Kingston and company were doing fairly well in their business, and the products were also in great demand. In the month of September, a new company started manufacturing shoes of the same quality but lesser price than Kingston Company. By locating the other company, the 3 big dealers ended the contract with the Kingston Company and started their business with another company since the prices were low. Now, Kingston Company has to suffer huge losses since their big dealers are not associated with them. They could not meet the company’s daily needs, and unfortunately, the Company went through insolvency. The management of Kingston Company should plan to get more reliable clients to avoid this insolvency situation.

Types of Insolvency

Below are the different types:

1. Personal Insolvency

It means when the individual is trapped with his liabilities and is now unable to pay off his debt irrespective of having assets in their books.

2. Commercial Insolvency

It is when the company is in the urge of liquidation but cannot pay off the debt obligations on time even when it has assets in its books.

Factors of Insolvency

There are certain factors that the company or an individual has to suffer.

Insufficient cash flow: When the company faces that its liabilities are less than its assets, but still the company is unable to pay off its debts, then this situation is known as insufficient cash flow. This is a rare situation but may occur and finally lead to insolvency.
Debt on the company: Whenever a company takes too much debt and is unable to pay them off, then insolvency occurs. The company should plan its debt accordingly to avoid insolvency.
No separate bank accounts: This is one of the most common reasons which lead to insolvency. The company sometimes has a common bank account which makes the liabilities of the company and the individual same, and thus if the debts are not paid off, then insolvency may occur.
Market competition: Market competition also plays a very vital role for the company. Sometimes it can be very useful, and sometimes it is not that good and healthy for the company since the company may take huge debts or can invest in some places, which may turn out to be a nightmare. Therefore the company should invest and take loans very wisely.
Lack of financial planning: The Company suffers from insolvency due to poor financing planning. The company should take all necessary steps to make good planning before any investment or loan decisions.
Trusting the clients too much: Now, this is a practical situation that leads to insolvency. For example, the company sometimes tries to maintain good relations with clients by giving them credit period, and sometimes they may not give full payment, but the company continues their services. Another situation is that company relies on some big clients, and in case they stop taking services from the company has to suffer insolvency.
Lack of good accountants in the company: Many companies compromises in hiring a good accounting team for their company. A good accounting team can help the management understand their expected budgets and exactly how much they can spend. In case the budgets are not prepared properly, then the company may indulge in overspending, and thus the entire budget may get disturbed, and if this is in huge money terms, then the company will have to suffer insolvency.

Consequences

The situation of insolvency can be very frustrating for the top management or the directors of the company. The creditors start to demand their money, and the directors also get involved in some legal proceedings. Some companies’ management decides to take voluntary liquidation of the company. This decision relies upon the company and is different for different companies. In some cases, Mergers and Acquisitions also take place, and thus, the management has to suffer these consequences whenever insolvency occurs. If the company is LLP (Limited Liability Partnership), then the business will go into liquidation, but the partner’s liability is saved in this case.

Key Takeaways

Insolvency occurs when the company is unable to pay off debts which they have taken. It is a type of financial distress that is very unfortunate but can be avoided by proper planning. The company goes into liquidation, and the identity of the company comes to an end. If the company is an LLP (Limited Liability Partnership), then the property of the promoters will not get attached.

Conclusion

Insolvency occurs when the company takes too many loans but is not able to pay off the same. As a result, the identity of the company is suffered because the company goes for liquidation. The top management should take all necessary steps to avoid the consequences of insolvency. In some situations, the company has assets, but it cannot pay off its liabilities; thus, insolvency occurs.

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