What Does Insolvency Mean?
Insolvency is the inability of an entity to pay its debts. In business, this usually means that a company’s liabilities (debts) are worth more than its assets, or more than the company itself. Were an insolvent company to liquidate its assets, it still wouldn’t have enough money to meet all of its financial obligations.
In some cases, however, a company may become insolvent even if its assets outweigh its liabilities because its most valuable assets aren’t easily convertible to cash, so the company, despite being worth more than its debt, is unable to pay its creditors in a timely manner.
Needless to say, when a company becomes insolvent, it finds itself in dire financial straights, and its shareholders may see the value of their equity plummet as the demand for the company’s stock takes a nosedive due to the risk of bankruptcy.
What Are the 2 Types of Insolvency?
Most cases of insolvency fall into one of two general categories:
- Balance sheet insolvency: Balance sheet insolvency occurs if a company’s liabilities outweigh its assets—either at present or in the future as calculated by evaluating incoming cash flows and upcoming expenses.
- Cash flow insolvency: Cash flow insolvency occurs when a company’s budget demonstrates that it is currently or will soon be unable to pay all of its upcoming financial obligations using its current and expected cash flows.
If a company fails the balance sheet or cash flow test, it is likely to become insolvent if it is not already.
Are Insolvency and Bankruptcy the Same Thing?
Insolvency and bankruptcy are closely related, as insolvency often leads to bankruptcy, but they are two different things. Insolvency is simply a financial situation in which a business or entity is unable to pay its debts, whereas bankruptcy is an actual court order that details how an insolvent debtor will sell assets, make payments on debts, and in some cases, be legally relieved of certain types of debt.
It’s important to note that not all cases of insolvency lead to bankruptcy. In many cases, an insolvent company can work directly with its creditors to establish a revised repayment schedule and get back on track financially by lowering costs and increasing cash flows.
How Does a Company Become Insolvent?
A company can become insolvent for a variety of reasons, and in many cases, multiple factors coincide to lead a company toward insolvency. Some of the most common factors that can contribute to insolvency include the following.
- Poor budgeting and/or accounting practices
- Ineffective business strategy by company management
- Decreased sales due to competition, decreased product demand, or price increases
- Excessive use of debt financing
- Failed investments
- Increased operating expenses
- Fines, lawsuits, and other unexpected expenses
- Poor employee retention
Some of the most notorious examples of insolvency in large, publicly traded companies have occurred in the banking industry. Many of these insolvencies, like the collapses of Bear Stearns and Lehman Brothers, occurred during the Financial Crisis of 2007–2008 fueled by the implosion of the mortgage-backed securities industry.
In both cases, the investment banks, dubbed “too big to fail,” had become overleveraged and assumed far too much risk in their investments, and it was a combination of these two factors that led to their insolvency and subsequent failure.
What Happens After a Company Becomes Insolvent?
When a business first begins to fail to meet its debt payments, it often begins the insolvency process by informing its creditors of its situation and attempting to negotiate revised repayment plans. In many cases, however, this simply isn’t possible, as too much debt and too little cash exist to facilitate an amenable agreement.
When it comes to large, publicly traded companies, any of the following scenarios could occur in response to insolvency.
Restructuring & Administration Changes
In some cases, an insolvent company may attempt to restructure internally, often by reorganizing departments, making layoffs, dissolving high-cost and low-profit departments, replacing key executives, and otherwise altering the way the business is administered in an attempt to cut costs and increase cash flow.
Liquidation
When a company liquidates, it sells all of its assets in order to raise cash. This cash is used to pay creditors, and then, if any remains, it is distributed to corporate bondholders, preferred stockholders, and common stockholders in that order.
Receivership
In some cases of insolvency, especially those of large, publicly-traded financial institutions whose collapse could potentially cause contagion throughout the finance industry due to the interconnectedness of banks, a receivership is established.
Often the receiver of an insolvent business is a state or federal governmental authority like the Federal Deposit Insurance Corp. (FDIC). When a company is in receivership, the receiving agency is responsible for taking control of the company and its assets, terminating unprofitable departments, liquidating some or all assets to raise cash, paying creditors and investors, and in some cases, securing a buyer for the failing company.
A notorious example of receivership occurred in March of 2023 when Silicon Valley Bank became insolvent due to a bank run spurred by a credit downgrade. The company was placed in the receivership of the California Department of Financial Protection and Innovation, which encouraged remaining depositors to leave their remaining money in the bank, then sold separate parts of the failed institution at a discount to First Citizens Bank and HSBC UK.
Frequently Asked Questions (FAQ)
Below are answers to some of the most common questions about insolvency that were not covered in the sections above.
What Is Insolvency Risk?
Insolvency risk is something investors consider before buying stock or bonds from a company. It refers simply to the likelihood that a company will become insolvent in the future. A company with high leverage ratios that makes risky investments may have higher insolvency risk—especially if it is a newer company that has yet to turn a profit.
Bond rating agencies like Standard & Poor's Global Ratings, Moody's, and Fitch Ratings may issue lower bond ratings (which range from D to AAA) to companies they perceive as having high insolvency risk.
What Happens When an Individual Becomes Insolvent?
Just like businesses, individuals can be solvent if they are unable to meet their financial obligations (like credit card and student loan payments). Much like a business, an individual can work directly with their creditors to negotiate revised repayment plans. If this is unsuccessful, an individual can file bankruptcy and work with a court to establish a plan to pay some creditors and forgive certain debts at the expense of their credit score.
Is Social Security Becoming Insolvent?
No, Social Security is not becoming insolvent.
In 2021, a report released by the Social Security Board of Trustees stated that the Old Age and Survivors Insurance (OASI) Trust Fund, which is one of many sources of funding for Social Security recipients, would be depleted by 2033.
This sparked a misguided rumor that the Social Security program at large would be insolvent and possibly face bankruptcy by that time. In reality, the program has many sources of funding, including deductions from the wages and salaries of the currently employed, and is expected to be a primary source of retirement income for many future American retirees.
