Difference Between Bankruptcy and Insolvency

Insolvency and bankruptcy are two dread words for any person or business. These are often baffling for a common man as he fails to differentiate between the two. The two terms are often used interchangeably but there are differences between the two. A business is said to be insolvent when the net assets are less than current net liabilities and bankruptcy follows insolvency. It is also insolvent when it is unable to pay its debts when they fall due. Bankruptcy is a legal term and a person or a business file for bankruptcy when they are unable to pay off their debts.

Bankruptcy

Bankruptcy is a legal proceeding; when a person is in a financial mess and cannot repay his debts, he can file for bankruptcy in a court of law. In some countries such as U.K., bankruptcy applies to a person or partnerships and not to a business. A different legal term ‘liquidation’ is used instead.

When a person is unable to meet his financial obligations and cannot repay his debts and his creditors start to threaten him, he may take recourse to bankruptcy. He files an application in a court to this effect and the court decides whether to liquidate his assets to settle the debts or to reorganize his loans to relieve the person as that he is able to pay back his debts.

Insolvency

Insolvency is similar to bankruptcy, and describes a condition when a person or a business is unable to pay debts when they fall due. It is not a legal term and just describes the condition of any business. When the cash flow in a business dries up and the liabilities cannot be met, the business is said to be insolvent though the assets may be more than the liabilities. Bankruptcy is however, not imminent, and there are ways to come out of insolvency. Normally businesses keep on going even when their balance sheet declares them to be insolvent and this is because of the cash inflows.

Difference between Bankruptcy and Insolvency

Bankruptcy is the last stage of insolvency. When it is clear that no other remedy is possible, an insolvent business may apply for bankruptcy. Insolvency is only a financial or accounting term, while bankruptcy is a legal term. In some countries bankruptcy applies to individuals, while insolvency applies to business. A business or a company do not file for bankruptcy, they rather face liquidation.

If a business has become insolvent, it is not necessarily bankrupt. Bankruptcy is a legal process to provide relief to a person whose business has become insolvent. At times businesses are insolvent as they have taken long term debts, but as long as they are paying their debts on time, though technically they are insolvent, they need not file for bankruptcy.

There are many reasons for a person filing for bankruptcy such as poor cash inflow, unexpected recession, a natural disaster or poor business management. But one thing is clear that the person or business has clearly become insolvent and he cannot repay his debts on time. The creditors become restless and insist for their payments. When a business cannot face these threatening creditors, it can ask for government intervention and apply for bankruptcy to come out of insolvency.