What is Insolvency?

//What is Insolvency?
What is Insolvency? 2017-10-05T03:14:16+00:00

Definition: Insolvency can be defined as the situation in which any organization or individual is unable to meet its short-term or immediate debt obligations. It can also be easily explained as the inability of a person or organization to pay its creditors.

What Does Insolvency Mean?

What is the definition of insolvency? Insolvency is also an accounting term that refers to the scenario in which a company’s liabilities exceed its assets. One of the biggest challenges for financial managers is to keep a company solvent by managing its funds and operations efficiently.

Investors and creditors pay close attention to this concept and use the operational cash flow metric to analyze it. This measure allows the company to calculate its ability to meet its cash obligations in the near future.

Solvency is about the ability to meet obligations. This comes down to cash and liquidity. A company or an individual might have more assets than liabilities, but many of the assets might be illiquid. The more fixed assets a company or an individual has, the higher the risk of becoming insolvent because in most situations fixed assets can’t be turned into cash fast enough. In this case, the company could become insolvent because it doesn’t have enough cash to meet its obligation and can’t covert its assets into cash fast enough.

Let’s look at an example.

Example

Fresh Fruit LLC is a company that sells fruits and vegetables. As part of their financial structure they have to pay their debt service the 15th of each month. The company has been struggling recently with overdue account receivables. As a result the company’s cash flow has been suffering. On February 15th, the company didn’t have enough cash to make its debt payment even though it had more assets than liabilities.

This company is insolvent to a degree. Even though the company assets exceed its liabilities, the inability to meet its monthly obligation indicates that it is insolvent to a degree. Will the entire company go under because of this? Probably not, but if it persists, the company will most likely have to sell off its assets to pay back these obligations.

Summary Definition

Define Insolvency: Insolvency means not having enough cash or access to cash to pay current liabilities and obligations.