The terms “bankruptcy” and “insolvency” are often used interchangeably in normal conversation, but they are different.
Insolvency
Insolvency is a financial state of affairs, and can be defined in two ways.
- A Cash Flow Problem
First, there is cash flow insolvency. A business is insolvent on a cash flow basis if it is unable to pay its debts generally as they become due or to meet its financial obligations during the normal course of operations. Whatever its net worth or assets, with cashflow insolvency the income or cash flow of the business is insufficient to pay its ongoing debts as they arise.
- A Net Worth Problem
Second, there is balance sheet insolvency. A business is insolvent by this measure when its liabilities exceed its assets. Regardless of cash flow, if the value of the property of the business, disposed of fairly, would fail to cover the total of the business’s obligations to creditors, then it is insolvent on a balance sheet basis.
Bankruptcy
Bankruptcy, on the other hand, is a legal state of affairs. When a business is bankrupt, its ability to trade, to buy and sell assets, take on credit, etc., are all suspended, and a trustee in bankruptcy is in charge of its assets and affairs.
All bankrupt businesses are insolvent, but not all insolvent businesses are bankrupt. Determining the status of a business which is “broke” is important in determining what its rights and obligations are.