What is the Difference Between Bankruptcy and Insolvency?

Though bankruptcy and insolvency are sometimes used interchangeably, they are in fact very distinct terms. Insolvency may lead to bankruptcy, but is an informal definition that describes a person who cannot pay debts or who has liabilities that exceed assets. Bankruptcy is a formal legal concept wherein the government has stepped in to resolve the debts of an insolvent person or business.

Bankruptcy and insolvency are often linked, since the state of insolvency may lead to formal bankruptcy proceedings. Nevertheless, in certain cases, a business may be able to operate without fear of bankruptcy despite being technically insolvent at the present time. To understand how bankruptcy and insolvency relate, it is important to understand the exact condition of insolvency.

There are two main types of insolvency: cash flow and balance sheet. Cash flow insolvency is generally a big problem, as it means that an individual or business is unable to pay debts when they are due. This can lead very quickly to creditors demanding bankruptcy proceedings against the debtor, known as involuntary bankruptcy.

Balance sheet insolvency occurs when the net assets of a business are worth less than the net liabilities. While this may be bad in the long term, as long as cash flow revenues are meeting debt obligations, a business is relatively safe from bankruptcy. Most business start out with balance sheets in the negative, as they take out loans to buy equipment, rent premises, and hire staff before they may any money at all. As long as the debts owed are long-term debts and regular payments are made, it generally isn't necessary for a business to have the assets to repay all debts at once.

The circumstances leading to bankruptcy and insolvency may be a result of poor business management, an unexpected market shift, a recession, or even a natural disaster. Whatever the cause, filing for bankruptcy is generally the result of a clear insolvency, at least on a cash flow level. As debtors default on debt, creditors tend to get increasingly vehement in their insistence on payment. When it becomes clear to the debtor that he or she has no way to catch up with liabilities, it may be time to declare bankruptcy and ask for help from the government. Bankruptcy, therefore, is the process of legally defining a financial situation as insolvent.

@hile insolvency may have no negative effects on credit, as long as payments are made, bankruptcy can severely damage credit for many years. When bankruptcy is determined, a person may find it nearly impossible to qualify for mortgages, loans, credit cards, or refinancing programs. In some regions, when bankruptcy is used to settle debts, it may include wage garnishment to repay creditors. Bankruptcy and insolvency are not always unavoidable in all cases, however, and many financial experts recommend getting good financial counseling as soon as negative balances become apparent.