Bankruptcy vs. insolvency: what’s the difference?
Bankruptcy and insolvency are often used interchangeably. However, they are two different things. A person that is bankrupt is insolvent, but being insolvent doesn’t necessarily mean bankruptcy. The terms also have different applications – for instance, insolvency generally refers to businesses, and bankruptcy to individuals. Here’s what the two words mean.
What is bankruptcy?
Bankruptcy is a legal process. It is undertaken when an individual or business can no longer afford to pay off their debts.
According to the United States Courts, a bankruptcy case normally begins when the debtor files a petition with the bankruptcy court. All bankruptcy cases are handled in federal courts under rules outlined in the U.S. Bankruptcy Code.
However, before it moves to a federal bankruptcy court, where your case is adjudicated, you must complete a credit counselling session to assess your income, debts, and assets.
A judge and court-appointed trustee will examine the assets and liabilities of individuals, partnerships, and businesses who’ve concluded they can’t pay their debts.
A petition may be filed by an individual, by spouses together, or by a corporation or other entity.
Bankruptcy is one way for individuals to deal with debt. It takes the pressure off an individual because, once you are bankrupt, your creditors can no longer demand payment, charge interest or take further legal action against you.
However, while it can reduce or eliminate your debts, bankruptcy can have serious financial consequences, including long-term damage to your credit score.
Different types of bankruptcy
There are different types of bankruptcies. These are commonly referred to by their chapters in the U.S. Bankruptcy Code.
Two of the most common types individuals use are Chapter 7 and Chapter 13. Businesses primarily use Chapter 11.
Chapter 7 bankruptcy is often known as the “liquidation” bankruptcy. It is most commonly used for individual filings.
The court will take control of your property, and your court-appointed trustee will sell the property the bankruptcy will not let you keep. The proceeds will be used to repay your creditors partially.
When you file for bankruptcy, you need to list the property you claim as exempt. The types of properties that can be exempt vary from state to state.
Chapter 13 bankruptcy creates a court-approved plan to repay all or part of your debt over a period of time – usually three to five years.
Under Chapter 13 bankruptcy, your property will not be sold if you keep up with the pre-agreed repayments.
Chapter 11 bankruptcy is often called “reorganization” or “rehabilitation” bankruptcy. It is most commonly used for business filings; however, individuals may also file.
Here, the debtor will remain operating while taking initiatives to stabilize its finances. This could include selling assets and reducing expenses. Under the court’s supervision, debtors can also attempt to renegotiate their debts with creditors.
When should I apply for bankruptcy?
You should only declare bankruptcy after you have exhausted all your other options but still cannot afford your debts.
Although bankruptcy can provide debt relief, it’s not a decision anyone should take lightly.
It impacts your day-to-day life, you risk losing valuable assets, and your credit score is affected for years. For example, a Chapter 7 bankruptcy stays on your credit report for seven years, while a Chapter 13 will stay for 10 years respectively. This hugely impacts your ability to borrow in the future.
Bankruptcy also means you cannot apply for a mortgage until two or four years after filing.
Depending on your circumstances, bankruptcy may or may not be your debt solution. If you’re facing severe debt and considering bankruptcy, it’s best to seek financial advice first.
What is insolvency?
Insolvency is a state of financial being. When you’re insolvent, you can no longer pay your debts when they’re due (hence, you’re insolvent when filing for bankruptcy). An individual or a business can be considered insolvent, but the term is most often used to refer to businesses.
Poor finance management, a reduction in cash inflow, a large unexpected expense, or an increase in expenses can all cause insolvency.
Examples of insolvency
Insolvency can happen quicker than you think. A slippery slope to debt can start with the following:
A cash flow crisis, e.g., you could overspend or find that customers are late paying
Loss of business contract: a client you depended on could suddenly change suppliers
Loss of customers: your customers may switch to a different product, or your service could become irrelevant with changing needs and markets
Unexpected and unaccounted-for costs, such as lawsuits, can also lead to insolvency. If sued, your business must pay large amounts of damages, which can be crippling if you don’t have the appropriate cover.
What’s the difference between bankruptcy and insolvency?
Looking at these examples, the main differences between bankruptcy and insolvency include:
Bankruptcy is a legal process or court order, while insolvency is a state of financial distress.
Bankruptcy is a type of insolvency, but there are others.
Bankruptcy isn’t the only way out of insolvency.
What preventative measures can I take to avoid bankruptcy and insolvency?
It’s important to understand what can lead to bankruptcy and insolvency so that you can spot warning signs early and intervene before debt piles up.
Prudent bookkeeping and budgeting can help you stay on top of your cash flow while taking out personal and business insurance can protect against unexpected lawsuits or loss of income.
Remember, even a healthy business may be insolvent if its finances are poorly handled. You might have significant assets and thriving custom and still be insolvent. Insolvency doesn’t mean having no money – it means being unable to pay debts when they fall due. You may find, for example, that the only way to settle debt is to sell off assets essential to your business – which will be impractical if you want to keep trading.
Running a business demands focus in many areas, and mistakes can crop up when trying to do it all under time pressures. Handing your accounts over to a professional reduces your risk of becoming insolvent.
How can I save my business from the brink of either bankruptcy or insolvency?
Contact a financial professional if you are on the brink of bankruptcy or insolvency.
This is likely to be a tough and emotionally draining time for you, with many hard choices to make. But it doesn’t have to mean the end of your venture. A financial professional can help you find the best solution for your business. This could include refinancing or restructuring your debt, setting up a company voluntary agreement, or guiding you through bankruptcy.
With the right approach and professional help, you can come out the other end with a stronger foundation for future growth.
Senior Content Writer
Rachel is a Senior Content Writer at Unbiased. She has nearly a decade of experience writing and producing content across a range of different sectors.