Small businesses often need to borrow to fund current operations and expansion. However, if the debts from borrowing pile up and there aren’t enough assets in the business to pay them off, the business may have an insolvency problem.
A business is solvent when it can pay its debts, but becomes insolvent when it can’t. Small businesses need to keep track of their expenses and debts because insolvency can lead to bankruptcy. Knowing the signs of insolvency and evaluating the possibility of bankruptcy is important to keeping your business afloat.
What Does Insolvent Mean?
“Solvency” is the term used to describe a company’s long-term prospects for success and its ability to pay its long-term debts. The business becomes insolvent if it can’t pay off those debts. Solvency depends on two factors: profitability and capital structure.
The profitability of a business is its ability to make a profit each year by spending less than what it brings in as income.
Its capital structure describes how much the business has in debt and equity (ownership), showing how much of its assets are financed by debt.
Insolvency has been called a “balance sheet test” because it occurs when the liabilities of a business are greater than its assets.
Solvency vs. Liquidity
While solvency is a long-term problem for businesses, liquidity is a short-term cash flow issue that affects working capital. Working capital is the ability of a business to have enough current assets (cash, receivables, and inventory) to sell to pay off current liabilities (payments due within the year).
Even if a business has a lot of cash, it can still head toward insolvency if most or all of that cash is borrowed.
Insolvency vs. Bankruptcy
Insolvency isn’t the same as bankruptcy. Insolvency is the financial status of a business at a point in time. Bankruptcy, on the other hand, is a legal process set up under U.S. law to help a business get out of debt. That help might be restructuring the business (Chapter 11 bankruptcy) or liquidating the entire business by selling all the assets (Chapter 7 bankruptcy). Help for a sole proprietorship, meanwhile, might come in the form of Chapter 13 bankruptcy, which includes both business and personal assets and allows for repayment over an extended period of time.
A common axiom to remember is that a business can be insolvent without being bankrupt, but it can’t be bankrupt without being insolvent.
Warning Signs of Business Insolvency
These are some common warning signs that a business may be insolvent:
- Creditors are suing for payment of debts
- Increasing use of credit cards or using one credit card to pay off another
- Withdrawing money from retirement savings (like a 401(k) plan)
- Paying penalties for late payments on business debts
- Dipping into sales taxes collected from customers or payroll taxes collected from employees
Not making payments on time increases your debts and can lead to severe penalties, which just add to your financial woes. For example, the IRS has strict penalties for not paying payroll taxes on time, including increased penalties for willful failure to pay.
Insolvency may be temporary—until it becomes permanent and there are no more solutions. You may be able to negotiate individually with creditors, get a loan from family or friends, sell some assets, or lay off employees to recover temporarily. But when you are no longer able to negotiate, your bills start piling up, all creditors turn you down, and the IRS starts seizing your assets, your business is likely insolvent.
Analyzing the Potential for Insolvency
You can also analyze your balance sheet to check on your risk of insolvency, using balance sheet ratios. A useful analytical tool is the total assets-to-debt ratio that looks at all assets of the business compared to long-term debts (those that last longer than a year). The formula is total assets divided by long-term debts. A good ratio is 2:1, meaning the assets are twice the amount of debt.
A higher ratio (more than 2:1) means higher security; a lower ratio (less than 2:1) means more risk of insolvency for the business owner.
What To Do if Your Business Is Insolvent
If insolvency becomes permanent, you might have to consider business bankruptcy. Showing you’re insolvent is the first step toward bankruptcy.
Federal bankruptcy law defines insolvency as the financial condition in which the sum of a business’s debts are greater than all its property at fair market value. One common way to assess fair market value is to ask what a willing buyer would accept and a willing seller would pay for the business property in a reasonable amount of time.
If the property must be sold immediately, it would be at liquidation value, which may be considerably lower than a typical business sale. However, if the liquidation value is less than the amount of the debt, the definition of bankruptcy is met.
Frequently Asked Questions (FAQs)
What happens when a business becomes insolvent?
Becoming insolvent can negatively affect your business credit rating and your ability to get business loans. If you can’t pay off your debts in a reasonable amount of time, and you can’t get new credit, you can become insolvent.
One quick way to tell if a business is insolvent is to compare business assets to its long-term debt. If the assets are less than two times the amount of debt, the business may not be able to get out of debt by selling its assets.
How does my business file for bankruptcy?
You have several options for filing bankruptcy depending on your business situation. You’ll need help from a bankruptcy attorney to do the filing and go through the process.
Chapter 7 (liquidating assets and closing the business) is best when you don’t have enough income to pay part or all of your debts and you don’t want to keep any assets. If you have an income or property and you can afford to repay at least some of your debts, you can file for Chapter 11 to reorganize your debts with the help of a bankruptcy trustee.
If you are in business as a sole proprietor, you must file your business bankruptcy combined with personal bankruptcy under Chapter 13.