What Does Insolvency Mean?
Insolvency means a business or individual is in a financial state where they can’t pay creditors on time. In such scenarios, the company and its stakeholders usually have two options:
- Out-of-Court Restructuring: The company and its creditors attempt to fix the problem without the court.
- In-Court Bankruptcy Filing: Seeking protection and structure under the U.S. Bankruptcy Code. Chapter 7 requires liquidating the debtor’s assets to pay creditors while Chapter 11 allows the company to continue operating while attempting to restructure its finances.
So, insolvency is different from bankruptcy. While insolvency is a financial condition, bankruptcy is a specific legal process that may be used to address insolvency.
What Criteria Lead to Insolvency?
Professionals usually use two primary tests to determine whether a company is insolvent.
The first one is the cash flow test, also called equitable insolvency. It assesses whether the debtor can pay its financial obligations including invoices, rent, loan repayments, and payroll as they become due. Analysts often review the Cash Flow Statement, short-term Working Capital, and overall liquidity planning to evaluate this. If the company cannot generate sufficient Free Cash Flow or maintain stable EBITDA, it is considered cash flow insolvent even if it has substantial assets on paper.
The second one is the balance sheet test, which examines whether total liabilities exceed total assets at fair value. This often requires a reassessment of asset values using valuation approaches such as Discounted Cash Flow Analysis (DCF) to estimate their realistic Present Value. If liabilities are greater than total assets, the company is considered balance sheet insolvent even if it still has enough liquidity to meet current obligations. In such cases, the company’s Equity Value may effectively be wiped out.
How Can Insolvency Be Avoided?
Fortunately, insolvency is something companies can avoid if they detect and address the underlying financial problems early on. The general steps to prevent insolvency involve strengthening liquidity or cash flow, capital structure, and operations.
Fixing liquidity issues prevents cash flow insolvency. It calls for accurate and regular cash flow forecasting to identify shortfalls early and make adjustments. These changes can include prioritizing collections from debtors or negotiating extended creditor terms.
Managing the capital structure diligently prevents balance sheet insolvency. The goal is to maintain a healthy balance between debt and equity. Companies can achieve this by monitoring the ratios, avoiding over-leveraging, diversifying funding sources, and negotiating loan covenants.
But most importantly, taking measures to address the underlying business issues or operations goes a long way. Depending on what the problems are, the solutions may include cutting costs, exiting loss-making activities, reassessing the business plan, and repositioning the business for improved cash generation.
What Are the Consequences of Insolvency?
Once a company becomes insolvent, the actions from management and creditors affect operations, reputation, and legal standing. Creditors may file lawsuits, seize collateral, or petition the court to force the company into involuntary bankruptcy. If a formal bankruptcy process is initiated, a trustee or the court-approved management takes control over major financial and strategic decisions.
Other consequences include:
- Reputational Damage: The news of financial distress can damage confidence among customers, suppliers, and the public. This can lead to possible termination of contracts with suppliers, clients, and partners.
- Loss of Access to Capital Markets: Trade creditors may tighten terms or refuse to extend credit, creating a liquidity spiral.
- Liquidation or Closure: If no viable path to reorganization exists, the company is forced to shut down. Assets are sold off to pay creditors in order of priority.
For the creditors, they may not recover all the money owed, as asset distribution follows a legal hierarchy with secured creditors paid first.
Typical Interview Questions Related to Insolvency
You will most likely get insolvency related interview questions if you’re seeking to join restructuring IB groups or consulting teams. The questions test your understanding of the process and problem solving skills within the context of corporate distress. Here are a few sample questions.
1. Can a company be insolvent without being bankrupt?
Yes, a company can be insolvent without being bankrupt. Insolvency means a company cannot pay its debts when they are due, cash-flow insolvency, or its liabilities exceed its assets (balance-sheet insolvency). Bankruptcy is the legal process initiated when a company formally seeks protection from its creditors under applicable law.
2. How do you analyze a company's financial statements to determine if it is insolvent?
Check for cash-flow insolvency by analyzing the Statement of Cash Flows for negative operating cash flow and the Balance Sheet for low cash-to-short-term-liabilities ratio. For balance-sheet insolvency, check the Balance Sheet to see if total liabilities are greater than total assets.
3. What’s automatic stay and debtor-in-possession financing?
Automatic stay is a protection in the bankruptcy process which immediately halts most legal actions, foreclosures, and debt collection efforts by creditors against the debtor and its property.
Debtor-in-possession financing refers to loans provided to a company while it is in bankruptcy, usually Chapter 11, to fund its operations during reorganization. These loans often receive priority repayment status.
