Insolvency and Bankruptcy

This resource seeks to help guide you through some of the issues surrounding the idea of insolvency. Most businesses when starting up might dream of success and profits. The reality in some cases is much less romantic: 20% of new businesses fail within the first two years of operation. In many cases, this is due to problems of cash flow rather than the business idea being wrong.

Strictly speaking, insolvency is the term we should use to describe the difficulties businesses face, whereas bankruptcy refers to the position an individual faces when unable to pay their debts. The two terms tend to be used interchangeably, and the basic problem is essentially the same.

What is Insolvency?

All businesses have revenues coming in from sales and money going out to pay for raw materials, staff, insurance, administration, advertising, loans and so on. The amount of money coming into the business, and when it comes in to the business, is crucial to allow a firm to be able to continue operating in the longer term.

Expenditures tend to be fairly regular in occurrence - insurance, staff salaries, rent and rates, for example, have to be paid at least monthly and raw materials used will depend on the level of production. If a business faces an increase in demand for its products, it may have to order in more stock and it needs the funds available to be able to do that.

If, for some reason, revenues are not coming in at the same rate then the business can start to experience problems. Without cash coming in, creditors (people who are owed money by the business) do not get paid and legally they can take steps to recover this money. If this happens then the business faces insolvency - an inability to be able to pay off their debts.

Cash Flow and Profitability

A business can be profitable in that, over a period, its costs are less than its revenue. However, if during that period it is unable to meet its obligations, then it can face insolvency. Profit, therefore, is not the same as cash flow.