July 16, 2024

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insolvency

Insolvency occurs when an individual or a firm is unable to meet its financial obligations. Accounting insolvency happens when total liabilities exceed total assets (negative net worth). Cash-flow insolvency involves a lack of liquidity to pay debts as they fall due. Balance sheet insolvency involves having negative net assets—where liabilities exceed assets. Insolvency is not a synonym for bankruptcy, which is a determination of insolvency made by a court of law with resulting legal orders intended to resolve the insolvency. A business can be cash-flow insolvent but balance-sheet solvent if it holds market liquidity assets, particularly against short term debt that it cannot immediately realize if called upon to do so. Conversely, a business can have negative net assets showing on its balance sheet, making it balance-sheet insolvent, but still be cash-flow solvent if ongoing revenue is able to meet debt obligations, and thus avoid default: for instance, if it holds long term debt. Some large companies operate permanently in this state. Considering the first definition of insolvency (“Insolvency is the inability of a debtor to pay their debt.”), this situation of ongoing balance-sheet insolvency with cash-flow solvency obviously does not qualify as “insolvency” defined that way. It has been suggested (for instance by Graeme Pietersz of Moneyterms) that the speaker or writer should either say technical insolvency or actual insolvency in order to always be clear – where technical insolvency is a synonym for balance sheet insolvency, which means that its liabilities are greater than its assets, and actual insolvency is a synonym for the first definition of insolvency (“Insolvency is the inability of a debtor to pay their debt.”). This avoids any confusion over which of the two definitions of “insolvency” are being used. If it is known that the second definition of insolvency (the definition which adds “or the state of having liabilities that are greater than assets”) is being used, then it avoids any confusion over which of the two possible required situations is manifest. While technical insolvency is a synonym for balance-sheet insolvency, cash-flow insolvency and actual insolvency are not synonyms. The term “cash-flow insolvent” carries a strong (but perhaps not absolute) connotation that the debtor is balance-sheet solvent, whereas the term “actually insolvent” does not.

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