It’s the worst outcome of running a business. You put years of effort, time, and sometimes even blood into your work and then the industry changes or a lockdown happens, and now you may own an insolvent company.
Let’s talk about what financial insolvency is and how to recognize insolvency in your business.
What does insolvency mean?
When is a company insolvent? Insolvency is when a company has more debt than assets and not enough cash flow to keep paying operating expenses.
It is important to understand the difference between insolvency and bankruptcy. Solvency and insolvency have to do with whether the value of your assets exceeds the value of your liabilities; bankruptcy is a legal path you might take (voluntarily or involuntarily) to liquidate your assets to pay down debt when you are insolvent.
Here are the signs in your own accounting that you may be dealing with insolvency risk.
1. Missing payments
If you’re starting to get demand letters from vendors and endless statements full of service charges, you need to figure out what’s going on. It could be that your accounts payable person isn’t cutting it or your accounting software needs better organization. But if the cause is that you don’t have the working capital to make payments, something’s wrong.
You can miss payments to vendors and not much happens for a while. But once you start missing payroll and not paying down your debt, your employees will leave and the bank will start to repossess your assets.
2. Maxed out lines of credit
It’s normal for a company to draw on its line of credit to make payroll or to bulk buy inventory. But lines of credit are meant to be revolving. You draw on the line to pay for something and then when the revenue comes through, you pay down the line and keep the difference.
When you’re drawing on the line and not paying it down, the bank starts to classify it as an evergreen line. The collateral for lines of credit are usually so-called trading assets, assets, such as accounts receivable and inventory, that are not meant to last for the long-term.
The bank does not like having a long-term debt secured with a short-term asset. Eventually, they will stop renewing it and require you to either pay it off or have your assets repossessed.
If you see that you have one or more lines of credit maxed out. Try to start making payments. Paying a little principal down is better than nothing. If you can’t make payments, you might have to start thinking about insolvency.
3. Declined bank loans
Banks are in business to do business. Big national banks sometimes crunch down on underwriting metrics, but if you’re getting declined by the local community banks, even with a government guaranty on the loan, it’s for a reason.
Additionally, banks will put covenants in your loan agreements for things like debt service coverage and debt-to-asset ratio. These covenants are there for the bank to be able to track how your business is doing. If you trip one of them, it could mean you are on the path to insolvency and the bank will likely want to meet with you. Eventually, they may call the loan.
4. Negative equity
Legally, there are two tests that determine if your company is insolvent. The first is the balance sheet test. It is simple. If you have more liabilities than assets, your company can be considered insolvent.
That said, just because you have more liabilities than assets doesn’t mean you have to cease operations. I made a number of loans to businesses with negative equity when I worked for a bank. Businesses that were purchased with debt or were not capital intensive often had very few assets other than cash, so when the cash was distributed out, they would have negative equity.
But the balance sheet test, on its own, doesn’t give the whole picture. You need to couple it with the test outlined in the next section.
5. Negative forecasted cash flow
The second test is the cash flow test. This test isn’t to just pull out your cash flow statement and check your operating cash flow. Cash-flow insolvency is when you forecast future expenses and sales and there’s no way you can cover expenses with your revenue.
It’s a good business practice to create an annual business budget and then track it throughout the year. It may make sense to do this for shorter periods. Construction companies track bid estimates to compare to final project costs. Many companies keep a cash flow spreadsheet going to predict when cash will be coming into various accounts so that payments can be made. The more you track it, the better you’ll manage it.
What to do with an insolvent company
If you have an insolvent company, it doesn’t have to be the end of your career. The first thing you should do is try to avoid bankruptcy. Many entrepreneurs who went bankrupt during the 2008 financial crisis couldn’t get a loan for a decade in a new business.
Bankruptcies stay on your personal credit report for seven years, but banks will pull LexisNexis reports and business credit reports that will go further back than that. Many banks have strict rules that they will not loan to people who have a bankruptcy; some will allow it but only after years have passed.
So if you have to deliver pizzas at night, hold off all your vendors, and restructure your loans with the bank to make it work, it’s worth it. Even if your current business does end up going bust, staying out of bankruptcy will make it easier to start a new business.
If the business is just too far gone, debt is piling up, and there is little to no asset value, you are better off engaging a bankruptcy attorney and starting the process yourself. It will likely go better in court if you are cooperating. And even then, it isn’t the end of the world to have a bankruptcy. There are banks who will work with you if you need them, but many businesses can be run without resorting to debt financing.
If you’re worried about business insolvency, it means something didn’t go as expected. That doesn’t mean you can’t be prepared. Analyze your financials every month if you think something is going wrong. Pay down your lines of credit and unload any assets you aren’t using. The more you can do to be ready and flexible, the better.