What Differences Are There Between Insolvency and Liquidation?
Many company owners have a hard time understanding the legal terms that apply to financially distressed businesses. Today, we are only going to focus on two of the recurrent words you’re likely to hear in this context. Insolvency and liquidation.
What Is Insolvency?A company is called insolvent when it is no longer able to discharge its liabilities. Basically, the liabilities of the company can't be covered because its assets are insufficient. In simple terms, the business doesn't produce enough money to pay its debts. Insolvency is tightly connected to the date when the debts are due for payment; if the company can't meet these deadlines, it virtually becomes insolvent. Once the company becomes insolvent, the director has the duty to act fast in order to rectify the situation. There are different methods to get an insolvent company back on track and avoid bankruptcy:
-Reorganizing or restructuring the company
-Granting creditors company shares
However, if the company is insolvent, the owner should stop trading unless there is a strong reason to hope that things can improve. In case of limited liability companies, the directors themselves can become personally liable if they continue the activities and incur further debts.
What Is Liquidation?A company in liquidation approaches its end of life. Liquidation is often the next step for companies that are insolvent and can't be saved. In liquidation, the company's assets are distributed among creditors and shareholders. The governing principle of this distribution is their claim's priority. The most important claims that get paid first are those of secured creditors, followed by unsecured creditors. After all the company's assets are distributed, the company is dissolved and ceases to exist. Yet, the debts basically still exist until the statute of limitations passes. The difference now is that there is no liable debtor who can pay so, the debts are finally written off.
Liquidation is conducted according to Chapter 7 of the Bankruptcy Code. In order to file for this chapter, a company doesn't necessarily have to be insolvent. To avoid another common confusion, it's important to keep in mind that not all bankruptcy forms trigger liquidation. Companies that file for Chapter 11 can restructure their debts and avoid liquidation.
What Differences Are There Between Insolvency and Liquidation?Now that we've seen how both insolvency and liquidation work, the distinction becomes clear; insolvency usually precedes liquidation. However, a company that is insolvent doesn't necessarily end up in liquidation because it can resort to other solutions and recover. On the other hand, not all companies that opt for a bankruptcy form which involves liquidation are insolvent in the first place.
If you have any doubts or concerns regarding your company's financial situation, my best advice is to reach out to a legal professional. A commercial lawyer can tell you more about the steps that typically precede insolvency or liquidation and help you avoid them.