Insolvency

What Is Insolvency?

Insolvency is a financial condition in which a person, business or other entity cannot pay its debts when they come due, or owes more than it owns. It describes the state of an entity's finances rather than a court process, although it often leads to one.

Two common tests describe insolvency:

• Cash-flow insolvency: the entity lacks enough liquidity to meet payments as they fall due, even if its assets are worth more than its debts.
• Balance-sheet insolvency: total liabilities exceed total assets, so the entity would have a negative net worth if its assets were sold and its debts settled.

These tests are different. A company can own valuable property yet be unable to pay its bills this month, or it can produce steady cash flow while carrying more debt than its assets cover.

How It Works

When an entity becomes insolvent, creditors may demand repayment, and the entity may have to sell assets, renegotiate terms or seek new financing. If the problem cannot be resolved outside of court, formal procedures such as bankruptcy may follow. These procedures vary by country. They may allow a business to reorganize its obligations, or they may require its assets to be sold and the proceeds distributed to creditors according to legal priority.

Insolvency is related to but distinct from solvency, which refers to the longer-term ability to meet all obligations. A business can be temporarily short of cash without being fundamentally insolvent, and a business can look solvent on paper while still facing an immediate liquidity crisis.

Why It Matters to Investors

For investors, insolvency signals serious financial distress. In a liquidation, creditors are generally paid before shareholders, so equity holders often recover little or nothing. Bondholders and other lenders also face the risk of partial losses. Reviewing a company's balance sheet and debt maturity schedule can help investors understand how exposed it may be to this risk, though no single measure predicts the outcome.