Insolvency

The term refers to a situation where a company's liabilities surpass the value of its assets. It focuses solely on the balance sheet, declaring a company "insolvent on the books" if its net worth is negative.

Accounting insolvency is determined solely by looking at the company’s balance sheet, without considering its operational capability. If a company borrows more while revenue decreases or if its assets decrease in value while liabilities stay the same or increase, it could be deemed accounting insolvent.

If a company seems insolvent on its books, debt holders may demand action. The company might try restructuring to ease its debt burden or face bankruptcy initiated by the creditors.

Factors affecting insolvency

Potential or upcoming lawsuits can result in growing future liabilities that might surpass a company’s assets. These potential liabilities can disrupt the company’s operations and lead to both accounting and cash flow insolvency.

Companies holding substantial fixed, long-term assets like property, buildings, and equipment can face challenges. If these assets become obsolete due to technological advancements, their value technically decreases, leading to accounting insolvency.

Cash flow shortfalls, where cash flows are insufficient to cover all debt obligations, pose a significant challenge. This liquidity crunch can compel companies to sell assets or profitable divisions to address the cash flow gaps, potentially leading to accounting insolvency.