In a recent conversation I had with a friend, she explained how one of her family friends had maxed out her credit cards, wiped out her savings, and was constantly getting calls from creditors. “She’s bankrupt!”, she said.
With some sympathy, I replied, “Sorry to hear that. Now, that she’s declared bankruptcy, at least, the calls should stop.” Surprisingly, she looked up to me and said, “she’s not bankrupt. I meant she’s broke!”
Bankruptcy and insolvency are two of among the most confusing finance terms for many people, and are sometimes even used interchangeably. Understandably, they’re related; however, they’re two distinct terms with different meanings.
In this post, we’re going to examine the subtleties to see how these terms are related.
Difference Between Insolvency and Bankruptcy
Both terms deal with having excessive debts.
However, insolvency is the inability of an individual to pay debts when they’re due, without being bankrupt. Insolvency occurs when the total cash flow and assets of a person are less than the debt. As a result, they’re unable to make payments at the stipulated time.
If you’re insolvent, there are many options to resolve the problem. This may involve a debt consolidation loan, debt settlement, debt management, or even declaring bankruptcy.
On the other hand, bankruptcy describes a legal proceeding that involves a person or business that is unable to repay their outstanding debts. After filing for bankruptcy, a Licensed Insolvency Trustee will be assigned to liquidate your assets and settle your creditors. It is usually the last resort when there’s no other way to resolve your insolvency.
Summarily, insolvency is a state of economic distress a person or organization might be able to work through, while bankruptcy leads to a court order. You can be insolvent without being bankrupt, but you cannot be bankrupt without being insolvent.
A Deeper Explanation of Insolvency
As you probably know by now, insolvency is when a person or business is unable to pay off debts with assets or cash. It signals a financially tough time for the person involved. However, there are ways out of it – either by borrowing funds, negotiating a payment or settlement plan with creditors and increasing income. There are two main types of insolvency: cash-flow insolvency and balance-sheet insolvency.
- Cash-flow insolvency
If you cannot pay off your debt because you don’t have the money, then you’re cash-flow insolvent. Cash flow is the increase or decrease in the amount of money an individual, business, or institution has.
Cash flow insolvency occurs when there’s no realistic way of generating enough cash to pay your debts. For instance, you can decide to sell your lawnmower to settle your due credit card payment to avoid cash-flow insolvency.
But when you run out of assets to pay off your debt and your income isn’t enough to cover it, you’ll have to critically evaluate your situation. For instance, if you’re about to increase your income, either by getting a better job or receiving a large inheritance, it is possible to work out a repayment plan with your creditors or engage the service of a debt management firm. However, if there’s no way of repaying, you may have to settle for debt settlement or declare bankruptcy in the worst-case scenario.
- Balance Sheet Insolvency
Balance sheet insolvency occurs when debts exceed assets. Although there might still be enough cash at hand, paying your debt with it isn’t sustainable and will eventually lead to cash flow insolvency.
Businesses use a balance sheet insolvency test to determine whether to take steps to stay afloat or declare bankruptcy. To determine balance sheet insolvency, all the individual’s or business’ inflows and assets are calculated. If all the inflows are less than the sum of the inflows and asset – a condition referred to as negative net assets – restructuring might help to avoid bankruptcy. But if the reverse is the case, the business might have to declare bankruptcy, after which the assets are sold to cover debts.
A Deeper Explanation of Bankruptcy
If there is no way to get out of insolvency, then declaring bankruptcy is usually the last course of action. After declaring bankruptcy, the court steps in to assist in the legal process of resolving the debt. The court decides how the bankrupt debtor will deal with unpaid obligations, either by selling nonexempt assets or reestablishing a payment plan. In some severe financial circumstances, the debt might be wiped off.
There are two major types of Personal Bankruptcy:
- Chapter 7
Chapter 7 bankruptcy allows liquidation of assets to pay creditors. A bankruptcy trustee is appointed to liquidate nonexempt assets like cash, securities, second house, and more. After the proceeds are exhausted, the remaining debt is discharged. However, the debtor will be allowed to keep exempts assets like necessary clothing, household goods, and more.
- Chapter 13
Chapter 13 bankruptcy involves the reorganization of debts. The court approves a plan to pay outstanding creditors within three to five years. None of the assets of the debtor is collected under Chapter 13 provided he/she sticks to the new payment plan.
Declaring bankruptcy can help individuals or businesses ease their financial burden, but it comes at a cost. Under Chapter 7, it leads to the loss of non-exempt assets. Furthermore, bankruptcy will greatly hurt your credit score, making it difficult to secure new loans or mortgage in the future. Chapter 7 bankruptcy will stay in your credit report for 10 years, while Chapter 13 will remain for 7 years. Finally, not all debts can be wiped off – not even under Chapter 7. Most secured debts, as well as student loans, alimony and child support, and unpaid taxes, are nondischargeable.
Conclusion
There are a lot of reasons a person can become insolvent, including divorce, loss of job or salary reduction, medical bills, unwise use of credit, or financial mismanagement. Businesses also become insolvent due to financial mismanagement or market forces beyond their control. When this happens, actions are taken to get off the financial distress caused by insolvency. But in some situations, there is no means of paying back debts. When this happens, the individual or businesses may have to declare bankruptcy.
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