There are also types of insolvency. Cash Flow insolvency occurs when a debtor can’t make a payment because they don’t have the money. Balance sheet insolvency is when your debt exceeds your unencumbered assets. Unencumbered refers to an asset or property that is free and clear of any creditor claims. Examples of common unencumbered assets are paid off houses, vehicles, or investments purchased with cash.
When does Insolvency become and Issue?
When a creditor seeks to collect and the debtor can’t pay what is due. Failing to pay debts usually leads to debt collection that leads to some kind of legal action. For example, if you own a house and can’t pay the monthly bond repayment, you’ll go into default which can lead to the repossession of your home. If you can’t meet minimum monthly payments on credit owed and don’t make payment arrangements, you’ll almost certainly be handed over to collection agencies.
If you can’t resolve the insolvency, either through payment arrangements or assistance from family and friends, bankruptcy might be the only way to stop financial haemorrhaging. This occurs when interest charges and legal costs increase debt substantially and there is no apparent way forward in settling the debt in the future.
Showing that you’re insolvent is necessary for establishing a bankruptcy claim. In South Africa this can be done through Voluntary Sequestration for individuals or Voluntary Liquidation for businesses. Through either process a large portion of the debt is written off and the remaining amount can be paid off either by selling assets or making payments arrangements over a set period.
Cashflow Insolvency
When you can’t pay a debt because you don’t have the money, you are cash-flow insolvent. Cash flow insolvency impacts both businesses and individuals. Usually it occurs when they have exhausted other ways of resolving debt. When you run out of assets to sell and places to borrow money from, and your income isn’t enough to cover your debts, you’ll probably be forced to negotiate a payment agreement with your creditors. This can be done directly or by using a debt management company to negotiate payment arrangements on your behalf.
If you’ve sold your assets and your income is not going to increase, you might not have an easy way out of insolvency. Voluntary Sequestration can assist in this regard as it will write off 75-80% of your debt. The remaining 20-25% can be paid off over a negotiated period or in full using retrenchment money, pension pay-outs or inheritance.
Balance Sheet Insolvency
Businesses commonly use a balance sheet insolvency test to decide whether to take steps to stay afloat or Liquidate. If income generated by a business is less than the expenses or debt owed by the business, and the value of the business’ assets are worth less than what is owed, it might conclude that liquidation is a necessity. However, if the business has assets that could be sold to cover debts, it might attempt to sell the asset and to bring the debt in line with what the business can afford.
A business can be cash flow insolvent, but balance sheet solvent, if it holds assets worth more than its liabilities. The reverse is also possible: A business can be balance sheet insolvent (more debt than assets), but cash flow solvent if its revenues allow it to meet its immediate financial obligations. Many companies that hold long-term debt operate continually in this state.
