Broadly speaking, ‘insolvency’ means inability to pay creditors.1 However, depending on the context, this colloquial usage may refer to any one of the several related concepts.2 To clarify definitional matters and to set out common terminology, it is necessary to distinguish between (1) balance sheet insolvency. (2) cash flow insolvency (or financial distress). (3) economic failure (or economic distress). (4) liquidation. (5) reorganization. and (6) insolvency proceedings or bankruptcy.
This is an accounting concept signifying that the book value of a firm’s assets is less than its liabilities. It should be distinguished from so called ‘cash-flow’ insolvency, in which case a firm is unable to pay its debts as they fall due. Such inability may be inferred from the fact that a company has failed to pay, on demand, a debt which is due. Financial economists commonly use the expression ‘financial distress’ to refer to the condition experienced by a firm which is having difficulty in paying its creditors. Although there are some terminological differences between authors, the phrase is often used to refer to the condition of a firm which is in substantial default on its debt obligations.
To a far greater extent than the balance sheet test of insolvency, financial distress is dependent on the structure of the repayments under outstanding debt obligations, and the nature of the assets available to satisfy them. Illiquid assets and large repayments may mean that a firm which is solvent in a balance sheet sense cannot pay its debts as they fall due. Conversely, a firm which has significant growth opportunities and debt repayments spread over a number of years may be insolvent in a balance sheet sense, but nonetheless be able to pay its debt as they fall due.