Did you know that 61% of small businesses around the world struggle with cash flow? What’s more is that 1/3 of those businesses cannot pay loans, vendors, employees, or themselves.
Proper cash flow management is a necessary strategy for every business owner to master. However, if your debts are too far gone, cash flow management won’t help you.
Instead, you need to learn about financial insolvency. Keep reading to learn more.
What Is Financial Insolvency?
Financial insolvency refers to when an individual or company can’t meet financial obligations to lenders when debts are due.
Before insolvency proceedings begin, you work on informal arrangements with creditors. For example, you might be able to set up alternative payment methods.
Insolvency can happen for different reasons, we’ll cover the common ones later on. You can contact creditors directly if you have cash flow issues and need to work on a new repayment plan.
Insolvency is repairable for companies. Understanding how to get out of insolvency involves knowing the different factors that dictate it.
First, you have controllable factors which can improve the bottom line. Business owners should understand the risk of taking on too much debt. Utilize funds correctly to avoid insolvency.
Doing so requires tracking money coming in and being able to anticipate future cash flow.
There are also uncontrollable elements like political issues, industrial outrage, and economic crashes that lead to insolvency. To avoid going into debt, have a contingency plan in place for these emergencies.
Businesses that plan for specific situations can stay afloat even when times get hard.
Factors Leading to Insolvency
Businesses become insolvent due to different factors. Most of which have to do with problems with cash flow.
We discuss the most common factors leading to insolvency below.
Investment Project Failure
The top reason that businesses become insolvent is an improper investment. The failure of a business expansion strategy can lead to unpayable debts.
If a business investment becomes unsuccessful, a company faces loss and likely becomes burdened with too many debts.
The root behind this financial issue is a lack of planning or financial analysis.
Poor Planning and Budgeting
An organization that lacks proper financial planning is likely to become insolvent. This comes down to an insufficient budget estimation and lack of cost-cutting.
Failing to hire a competent manager is one way to suffer. In the end, your business pays the price of losing capital and assets.
Improper Debt Management
Business loans are great for companies that can afford funds but businesses sometimes get over-leveraged. This means the cost of borrowings exceeds business earnings.
Management ignoring the ability to repay loans is the cause of this issue.
Inefficient Finance Department
Every business needs a financial department either hired in-house or outsourced. This team should be filled with highly skilled financial executives.
If you hire a team that lacks experience, their decision-making can easily cause problems with business assets and financial resources.
During insolvency proceedings, legal action will be taken against the insolvent company. Assets might be liquidated to pay off outstanding debts.
Business owners can contact creditors to restructure debts in installments that are more manageable to them. Creditors tend to work with this approach because they want repayment despite a delayed schedule.
An insolvent company can proceed with daily tasks in any of the four ways:
- Company voluntary arrangement
A business owner will need to assemble a realistic plan proving how they can reduce company overhead while continuing business operations.
The proposal will detail how the business can produce enough cash flow to continue profitable operations and pay debts at the same time.
Insolvency vs. Bankruptcy
Business bankruptcy is not the same as financial insolvency. Insolvency is a type of financial distress in which an entity can no longer pay its business debt.
The IRS defines this as when the total liabilities exceed total assets.
Bankruptcy is an actual court order that depicts how an insolvent business will pay creditors. It might also state how a business will sell its assets to make payments.
A corporation can be insolvent without being bankrupt. Insolvency can be temporary, but if it extends, it can lead to bankruptcy.
Types of Insolvency
There are different types of insolvency that test financial distress. Use these methods before you declare bankruptcy for your company.
Balance Sheet Insolvency
You can test for financial distress through balance sheet records. A balance sheet should list corporate assets and liabilities.
If the overall liabilities go beyond the valuation of the total assets, the company becomes insolvent. In this scenario, the net assets are likely negative.
Most of the companies in this situation go bankrupt.
Balance sheet insolvency examines net assets by deducting the total liabilities from the total assets. A negative value requires the help of an expert to save the company.
Cash Flow Insolvency
If a company faces a cash shortage, the business is unable to pay creditors and pay back operational debts. In this situation, the liabilities exceed the liquid assets and create a negative cash flow.
These problems can be anticipated. If you notice cash outflows minus cash inflows create a negative value, you can resolve the problem.
You can review the terms and conditions of your current repayment plan with creditors.
Pre Pack Administration
A pre pack administration arrangement can help with insolvency issues. The sale of all or part of a company’s business or assets is negotiated before an insolvency practitioner.
Pre pack administration services can help you complete this form of insolvency.
In this case, company debts are written off and a business can resume practice. Other benefits of pre pack administration include:
- Value protection
- Job preservation
- Reduced costs
Creditors are consulted in advance. Although alternative routes are more common, they provide no better return for creditors.
Dealing With Business Debt
Dealing with business debt is never an easy thing. Financial insolvency helps companies repay their debts on a different schedule while continuing to run their business.
Understanding insolvency can help you if your debts become overwhelming. Knowing the factors that lead to insolvency can keep you from going bankrupt.
Consider the solutions for financial insolvency in this guide and keep coming back to this blog for more business tips.