Not all business ventures go as well as planned. Unfortunately, some businesses meet with financial hardship and become insolvent. Insolvency is the state of being unable to pay the money owed, by a person or company, on time. In business, insolvency occurs when a business is unable to pay its debts when they fall due for payment in the normal course of business. The nature of insolvency and its outcomes will vary based on the structure of that business. For example, insolvency affects sole traders differently to companies. Within this there are two types of insolvency as well. Accordingly, we have outlined these differences for you below.
Cash-flow insolvency
This occurs when a business as either a person or company has enough assets to pay what is owed, but does not have the appropriate form of payment. For example, a company may own lots of land, but not have the cash stream to pay debts. This can be quite common. Sometimes cash-flow is slow, but may pick up again. Therefore, is important to keep debtors in the loop.
Balance-sheet insolvency
This type is when a business as a person or company does not have enough assets to pay all of their debts. The person or company might enter bankruptcy or liquidation, but not always. Sometimes, payment plans may resolve the problem. Finding ways to solve the problem is often a better solution for all parties.
Sole traders
Businesses conducted by sole traders become insolvent in different ways. As a sole trader, your business is not a separate legal entity to you. If you have registered a business name under your own personal ABN, you bear the liabilities of that business. Therefore, if your business becomes insolvent, you can be declared a bankrupt. This only applies to legal persons and not companies. This is because companies are a separate legal entity.
Companies
As companies are a separate legal entity, they are subject to different insolvency laws than that of a legal person. Unlike sole traders, it also means that shareholders, directors, and people working within that company do not become insolvent. The Australian Securities and Investments Commission provides guidelines for this on its website. Insolvency for company businesses can occur in the following ways:
- Liquidation is the orderly winding up of a company’s affairs. If a company becomes aware of looming insolvency it may decide to sell assets and terminate the company. Companies do this of their own accord, but sometimes it is enforced by a court
- Voluntary administration is where an external administrator is appointed to investigate the insolvency and report findings
- Receivership is where a receiver is appointed to sell company assets in order to pay secured creditors
Ultimately, insolvency is not something any business yearns for. However, it can happen, and is outside the control of the business. That is the nature of a competitive landscape. In slow times, the costs of running a business can outweigh the revenue made. Keeping close tabs on your business affairs can help prevent these issues from arising. However, in the event that your business is facing problems, it may be wise to consult a business lawyer for advice.
