To gain an understanding of the two terms, I will separate them and provide the legal definition and explain the term from the business perspective. Once you understand the terms, I will then explain how a business can slip into the legal quagmire and how the owner of the business can lose his rights to control the business. Finally, I’ll describe some tools to help prevent this entire process from unfolding.
The key to this term is that it is not a formal legal status. In general it refers to the inability of the business operation to pay its current obligations within the agreed upon time periods. There are two types of insolvency. The first is referred to as ‘equity’ insolvency and the second type is termed ‘balance sheet’ insolvency.
The most common form of insolvency as most businesses if not all businesses will experience a cash flow issue to pay their bills. I’m not sure why it is referred to as ‘Equity Insolvency’ because the term equity usually deals with the bottom section of the balance sheet. But I believe it received this label because there is inadequate cash (working capital or equity) to pay your bills.
It is effectively the inability to pay current liabilities when they come due. Often it is seen as a shortage of cash in an accounting period necessitating deferral of payment of bills due. This form of insolvency is strictly the lack of cash to pay your bills. A lack of cash doesn’t mean you are poor businessman, it just means that there is a true, hopefully temporary, issue with the ability to pay your current bills.
This form of insolvency is stated in many different ways:
- Slow Pay
- Cash Flow Issues (Shortage)
- Failure to Meet Obligations
- No Pay
The primary culprit of this situation is the manager’s poor operational decision(s). Sometimes the cash is used to purchase large ticket items or management allows receivables to build (increase in financial value). This will tie up cash normally used to pay current obligations.
Balance Sheet Insolvency
Another type of insolvency exists due to balance sheet items. This form of insolvency is generally more serious than the Equity Insolvency described above. Simply stated, the current liabilities exceed current assets. Or, it could exist on a slightly larger scale which is all assets are less than all liabilities. In effect, there are two forms of balance sheet insolvency:
- Current liabilities > current assets – also referred to as a current ratio of less than 1.00
- Total liabilities > total assets – equity section is negative
The following paragraphs describe the sources of these two forms of balance sheet insolvency:
Current Ratio < 1.00
In general the current ratio equals ALL CURRENT ASSETS/ALL CURRENT LIABILITIES. When the total current assets are less than total current liabilities, your current ratio is less than 1.00. This infers a situation whereby management is financing operations via vendors or via short term debt. There is a multitude of ways to get the balance sheet in this condition. The most common management decisions that generate higher current liabilities include:
- A bank debt becomes short term suddenly due to terms or conditions.
- Long term assets were purchased using short term debt obligations such as credit cards or short term notes
- Recognition of sudden obligations due to retroactive decisions (fringe benefits, contract terms, tax issues, etc.)
Management decisions that negatively affect current assets without affecting current liabilities include:
- Early payment of long-term obligations
- Write-off of account receivables due to customer default
- Reclassifying a current asset such as cash to a long-term receivable or some other asset (purchase of patent or copyright)
- Purchase of fixed assets using only current assets
If you review the current ratio formula, any decrease in current assets without affecting liabilities reduces the current ratio. In addition any increase in current liabilities with no changes to current assets also decreases the current ratio.
Negative Equity Section
This would exist if the equity section of the balance sheet is a negative balance. In effect, the owner has not capitalized the operation sufficiently to meet the day to day cash needs. For an understanding of the equity section of the balance sheet read: How to Read a Balance Sheet – Equity Section Simple Format.
How can this happen?
Well, there are several reasons for inadequate capital. The following is a short list of the more common reasons and why they happen:
- Poorly Capitalized – the owner of the company or the shareholders failed to monetize the capital needs of the company from the start. You see this situation more frequently with new businesses or capital intensive types of business operations. Examples include businesses utilizing heavy equipment or requiring huge inventories of stock to meet the needs of customers (think of auto parts stores, marine repair shops, manufacturing, site developers etc.). The best solution is more equity based capital in the form of cash in exchange for stock.
- Negative Retained Earnings – this exists as a direct result of poor operations. In effect, you are generating a loss on the income statement which defaults into the retained earnings account. These losses consume assets in order to continue operations. At some point, you will begin to notice the effect of poor operations in the ability to meet your regular obligations i.e. pay your bills.
- Strong Distributions/Dividends/Draws – this doesn’t happen too often but I’ve seen this happen with operations that have been in business for long periods of time. The owner(s) become accustomed to certain minimum distributions or dividends and continue to take money out of the company at the old rates when cash is needed for other purposes. These other purposes include expansion, seasonal adjustments, or even temporary lulls in profitability. By removing equity from the balance sheet, it makes it more difficult for management to meet their obligations as they come due.
So balance sheet insolvency is caused by a current ratio of less than 1.00 or a negative equity section.
This exists when you finally can no longer take the stress of dealing with the insolvency issues. This is a legal term meaning you have requested the federal government appoint someone called a trustee to help you. This is referred to as a Chapter 11 Bankruptcy. You believe that under a reorganization plan, that you can fully recover from the current situation but you need the federal government’s help in keeping your creditors at bay. This is often used by larger operations and small businesses with a lot of employees. Remember, the second reason a business exists is to provide secured employment for your staff. Bankruptcy isn’t necessarily about you; it is about protecting them too.
Another form of bankruptcy is called Chapter 7. This is straight forward liquidation of your assets and the proceeds will be prorated and distributed to your creditors. This is a total shutdown of your business. If you have employees, they are out of a job. Now you see why Chapter 11 is a good alternative.
Signs of Insolvency and Bankruptcy
How can a business get into this situation? Most businesses don’t go bankrupt they just stop operating and shut down. These are your smaller operations, usually the one or two man types of operations. The owner fails to pay his bills and the creditors refuse to continue dealing with the owner. So when you hear that statement ‘95% of all business go out of business within five years’; this is what it is referring too. Bankruptcy is nothing more than a formal legal process.
Before getting to the point of going out of business, the owner’s do receive signs of insolvency. The most prevalent sign is a lack of activity which is customarily measured in sales. Without sales, why would you want to continue operations? For those businesses that have been around awhile and do have regular sales, what are the signs of insolvency which ultimately leads to bankruptcy?
For starters, it’s the vendor phone call to you asking ‘Where is the money?’ This is an example of slow paying your vendors or no paying of your vendors. This is a sign to management that a mistake has been made somewhere recently causing a shortage of current assets to meet the current obligations: review the Equity Insolvency above.
But if you are a decent operation and you keep up with your paperwork, the real signs show up on the balance sheet. Look at the current ratio if it is less than 1.00, then odds are that you have some insolvency issues. Review total assets to total liabilities; again is there negative equity here? This is where good accounting is valuable to your understanding of what is going on around you.
Remember, insolvency isn’t just a sudden occurrence, most often it starts out slowly and builds up to the point where it is a really serious issue. Once you reach this level, the insolvency issue requires daily attention to continue delaying payment etc. The old adage of robbing Peter to pay Paul is in full operational mode in this situation. At some point, you the owner can no longer bear the stress and you seek alternatives to relieve yourself of this responsibility. Bankruptcy or total liquidation and cessation of operations commence.
Prevention Methods and Early Indicators
In the above section I explained that there are signs of insolvency. The primary sign is the phone call from a creditor asking what is going on that you are slow paying or not paying your bills. But there are other indicators. The best early indicators are as follows:
- A continuously decreasing current ratio over time.
- Poor financial performance in terms of the income statement, i.e. losses on the profit and loss statements. Worse yet, increasing losses from one period to the next.
- Inability to pay all your bills each week; a good operation should be able to pay all their respective bills weekly.
- A desire to purchase fixed assets without proper capitalization.
There are a lot of prevention tools available to the business owner, but the most valuable one is the 6 inches between your ears. Use your head and watch the signs in the financial reports. Are we making profit? Are we making adequate profit? Is the current ratio increasing or decreasing? Do we have temporary sources of cash in case of sudden negative business economics?
You should conduct weekly financial meetings with your accounting staff to make sure you can pay all your bills and if not, WHY? Learn to monitor the cash flow and make sure production is adequate and operating efficiently. It is about being an active manager of your business. Constantly inspect what you expect to happen. This is what owning a business is about.
Conclusion – Insolvency and Bankruptcy
In general, insolvency leads to bankruptcy. There are two forms of insolvency. The first is a cash flow issue referred to as Equity Insolvency. The second type, Balance Sheet Insolvency, occurs when either the current ratio is less than 1.00 or the equity section of the balance sheet is negative. As the owner of the business, you need to be on the lookout for signs of insolvency; the most common outward sign is a phone call from your vendor asking why you are late paying your bill. However, there are other tools available to watch out for insolvency. Monitor your profit and loss statement, review your balance sheet regularly, meet with your accounting staff weekly. Pay your bills weekly. Use your head to make sure financial operations are running smoothly.
If you fail to monitor and address the situation, insolvency will become an overwhelming burden forcing you to seek legal relief from the stress. This relief is in the form of bankruptcy or total shutdown of business. When the owner seeks out relief, it can occur in two methods. You may elect Chapter 11 which protects the business from creditors while the business is reorganized under the guidance of a federal trustee. Or you may seek Chapter 7 which is total liquidation of business assets and the creditors are paid their prorated share of the proceeds.
Constantly review the financial information and stay on top of paying your bills. Watch out for the signs of insolvency and you’ll prevent bankruptcy. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.