Insolvency is when a person or business cannot make debt payments on time. Though it can happen for a number of reasons, it’s usually the result of poor financial planning. Look out for these common causes of insolvency to keep your finances safe.

Before you go into debt, you should make a plan to pay back your creditors and avoid financial problems. Otherwise, you could jolt your finances, miss due payments and put yourself or your business in a state of insolvency. Remember when and how much you need to pay back each month and be ready to cover contingencies, like a sudden loss of income or spike in your expenses.

In general, there are two kinds of insolvency: one is short-term, and the other long-term. What insolvency is called and the legal and financial consequences it has can vary by jurisdiction. Here’s a general overview about the types of insolvency.

  • Cash-flow insolvency. Cash-flow insolvency is considered temporary. A person or business may not have enough cash but has other assets to make due payment in the short term. Because assets (e.g. property, savings, investments, etc.) exceed liabilities (e.g. debt), they can be used to raise liquidity (i.e. money).

    For example, Martin already has a mortgage but took out an auto loan without thinking about his ability to repay. Now, he can’t keep up with his debt payments, which are higher than his income. He could, however, sell off the shares he holds in a company to get cash and pay down or settle his auto loan. This would get him out of short-term insolvency.

  • Balance-sheet insolvency. In balance-sheet insolvency, a person or business's debt is so big, neither the income they have nor the assets they can sell off will be enough to repay it. If the law allows, they could sell some assets or restructure their debt to repay their creditors. A business’s partners could raise capital or get extra financing to help balance their budget, regain solvency and avoid winding up.

    Imagine a company that suffered losses in recent years and has taken out several loans to pay expenses, including vendors and employees. It can’t get out of debt because its liabilities now exceed its assets (e.g. property, plant and equipment) and no bank will lend it more money. Therefore, the company can’t continue in business. One option it has is to sell off assets and reach a payment agreement with its creditors.

Insolvency vs bankruptcy

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In some countries, balance-sheet insolvency is part one of bankruptcy; in others, “insolvency” and “bankruptcy” each mean something different. In the UK, for instance, insolvency law applies to businesses, but bankruptcy law applies to people. In Spain, the so-called “Second Chances Act” (Ley de Segunda Oportunidad) allows individuals and sole traders declared insolvent to have their debts cancelled, stave off bankruptcy and start afresh.

Consequences of insolvency

Insolvency hurts you in the present and in the future. With cash-flow insolvency, if your search for liquidity prompts you to miss due payments, you will have to pay late-payment interest. With balance-sheet insolvency, even if you sell off assets, your credit history (which consists of your debts and defaults) will be damaged. This will make it harder for you to get credit, loans and other financial products and services in the future.

Insolvency can become a criminal offence if the law is broken in order to avoid debt repayment. Bankruptcy fraud includes concealing assets to avoid using them to pay a debt or falsifying documents to cover up your finances In some countries, bankruptcy fraud carries fines or even jail time.

Poor financial planning and debt scheduling can harm your financial health in many ways. Keep your income and expenses balanced in order to save money, invest, increase business revenue and meet other financial goals.

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