A state of insolvency exists when either an entity is unable to pay its debts as they mature and come due for payment, which can be seen through the analysis of the company’s cash flows and its balance sheet. Cash-flow insolvency is the financial condition of a company when it is unable to pay its debts as they mature and come due for payment in the ordinary course of business. Balance sheet insolvency exists when a firm has insufficient assets to pay all its debts in full or its aggregate balance sheet liabilities exceed its assets (negative net assets).
When an individual or entity is unable to pay its debts as they fall due or has an excess of liabilities over assets, they are considered to be insolvent. Whereas equity insolvency generally leads to a negotiated resolution, balance sheet insolvency results in either a troubled debt restructuring or liquidation.
| Balance Sheet Insolvency – Negative Equity (Example) | |
| Assets | |
| Current Assets | $ 1,000,000 |
| Noncurrent Assets | 4,000,000 |
| Total Assets | 5,000,000 |
| Liabilities | |
| Current Liabilities | $ 750,000 |
| Long-Term Liabilities | 4,500,000 |
| Total Liabilities | 5,500,000 |
| Equity | |
| Total Equity | $ (500,000) |
If a company holds illiquid current assets against short-term debt, it may be cash-flow insolvent but balance sheet solvent. Conversely, if ongoing revenue is able to service a company’s debt, especially if it holds long-term debt, it may be balance sheet insolvent but cash-flow solvent.
In some jurisdictions, a debtor is deemed insolvent by the mere fact that its debts exceed its equity. Once a state of insolvency is reached, it is generally illegal for a debtor to continue to pay some creditors in preference to other creditors. Whereas a firm may continue in business under a declared protective arrangement while it tries to achieve recovery in some jurisdictions (e.g., USA), in others it is illegal for a company to continue in business while insolvent (e.g., Austria).