# Insolvency: What It Is and Potential Causes

## What Is Insolvency?

Insolvency refers to a business that can no longer pay its debts. A company might be unable to repay creditors if it's struggling financially. The company might have had a significant drop in income due to lost sales, increased expenses due to the cost of goods or labor, or the business might be suffering from poor decisions.

While insolvency typically refers to businesses, individuals can become insolvent too. Simply put, if you can't pay debts (like your credit card, student loans, medical bills, or [mortgage](https://www.investopedia.com/mortgage-rates-5094943)), you're insolvent. However, people who no longer can manage their debts are also more likely to face bankruptcy, which isn't the same as insolvency.

### Key Takeaways

*   Insolvency is the inability of a business or individual to repay their debts.
*   Businesses might become insolvent if they can't repay creditors, pay their employees, or continue to operate.
*   Businesses have options if they become insolvent—they might choose to restructure and work with creditors—while individuals could file bankruptcy or have the debt excluded from their taxes.

![Insolvency](https://www.investopedia.com/thmb/XCDGpVGIfVA0lvIJjQb2xBl4na4=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/insolvency.asp-final-15cb186ac9544f8a9b12416af2478ad8.jpg)

*— Investopedia / Theresa Chiechi*

## How Insolvency Works

Insolvency is a state of financial distress in which a business or person is unable to pay their bills. There are a few different methods to determine if a business is insolvent. First, a company is insolvent if its liabilities exceed its assets. This is known as balance-sheet insolvency. The other is cash-flow insolvency, where, over time, a company can't continue to pay its debts because of liquidity issues.

If a business becomes insolvent, formal procedures begin. This is legal action against the insolvent business and usually means that [assets](https://www.investopedia.com/terms/a/asset.asp) are liquidated to pay back creditors in what is known as [Chapter 7 bankruptcy](https://www.investopedia.com/terms/c/chapter7.asp).

Another option for insolvent businesses is negotiating repayment options with creditors. Since creditors are more likely to get payments, many are willing to adjust payment schedules to accommodate the struggling business.

The business also might decide to [restructure its debt](https://www.investopedia.com/terms/d/debtrestructuring.asp) in order to continue operating. This involves developing a detailed and realistic plan to operate at a reduced cost. Most importantly, the plan has to show how the business can be profitable enough to repay its debts.

> **Fast Fact**
>
> If an individual becomes insolvent and has debts forgiven, the Internal Revenue Service (IRS) doesn't consider the debt to be taxable income.

## Potential Causes of Insolvency

Insolvency can be caused by many things, ranging from poor financial decisions to factors outside of a business or individual's control.

*   **Poor cash flow management**: If a company's income fluctuates and management can't cover operating expenses when income is inconsistent, it might struggle to cover overhead expenses.
*   **Poor oversight**: If the company lacks a clear business strategy, doesn't treat its employees well, or makes business decisions without much consideration, it can cost the company money in the long run.
*   **Excessive debt**: If the company doesn't have a good handle on its budget, it may quickly find that it's spending more money than it's making.
*   **Rising costs**: If a company's vendors charge more for goods and services, companies might struggle to make a profit or risk losing customers.
*   **Failed investments**: If a company made poor investment choices without doing research or if economic conditions deteriorated, it may be impossible to count on investments to improve the company's finances.
*   **Declining sales**: If a business doesn't innovate, it risks losing its customers. When consumers take their business elsewhere, a company loses valuable income.
*   **Lawsuits**: If a company settles a lawsuit and must pay substantial damages, it might not be able to continue operations, which cuts off the company's income.

> **Fast Fact**
>
> Types of insolvency include cash-flow insolvency and balance-sheet insolvency. Cash-flow insolvency happens when a company has the assets to cover its debts, but they're in the wrong form, such as real estate instead of liquid funds. Balance-sheet insolvency, on the other hand, indicates a lack of assets in any form to cover debts.

## Insolvency vs. Bankruptcy

Insolvency and bankruptcy aren't interchangeable terms. Insolvency describes a state of financial distress. It's not a court order like [bankruptcy](https://www.investopedia.com/terms/b/bankruptcy.asp), which is meant to remedy insolvency. Businesses and people can find themselves insolvent for many reasons, but they can also do things to remedy their financial situations. Bankruptcy is one way they can become solvent again.

Through bankruptcy, a court can discharge debt so an individual or business can cover their expenses going forward. Keep in mind that bankruptcy isn't the only way to become [solvent](https://www.investopedia.com/terms/s/solvency.asp). It's possible to restructure payments and work with creditors to manage expenses. Individuals and businesses might also be able to improve their income streams in order to satisfy debts and become solvent again.

### Insolvency vs. Bankruptcy

Insolvency

*   Refers to a financial state
    
*   Can be reversed
    
*   Might lead to bankruptcy
    
*   Can impact credit ratings
    

Bankruptcy

*   Refers to a legal process
    
*   Is irreversible
    
*   Is a result of insolvency
    
*   Has a direct negative effect on credit ratings
    

## The Bottom Line

Being insolvent is a serious problem, whether you're running a company or you're managing your household. Fortunately, it's reversible, and you can take steps to stay solvent in the future. For most companies, this means improving financial management, taking care of employees, and following industry standards. Individuals can stay solvent by improving income streams, not spending beyond their means, and sticking to a realistic budget.  

> **Article Sources**
>
> 1.  Cornell Law School: Legal Information Institute. "[Insolvency](https://www.law.cornell.edu/wex/insolvency)."
>     
> 2.  IRS. “[Chapter 7 Bankruptcy - Liquidation under the Bankruptcy Code](https://www.irs.gov/businesses/small-businesses-self-employed/chapter-7-bankruptcy-liquidation-under-the-bankruptcy-code).”
>     
> 3.  IRS. "[What if I Am Insolvent?](https://www.irs.gov/newsroom/what-if-i-am-insolvent)"
>     
> 4.  CFI. "[Insolvency](https://corporatefinanceinstitute.com/resources/commercial-lending/insolvency/)."