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Step-by-Step Guide to Understanding the Insolvency Concept in Accounting

Last Updated August 30, 2023

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What is the Definition of Insolvent?

In accounting, a company deemed “insolvent” is one that can no longer meet its financial obligations to lenders.

While a company can become distressed for numerous reasons, the primary catalyst is more often than not an over-reliance on debt as a source of funding.

Debt financing may have its set of benefits – such as the interest being tax-deductible (i.e. the tax shield) and the avoidance of dilution in the equity interests of existing shareholders – but the drawback is that debt often comes with a mandatory payment schedule.

In particular, there are two payments that must be met on time per the loan agreement:

  1. Periodic Interest Expense
  2. Principal Repayment

The interest expense, unless structured as paid-in-kind (PIK) interest, must be paid in cash per an agreed-upon schedule.

Conceptually, the interest expense payments are the cost of borrowing and are one of the main sources of return for debt lenders, i.e. there is no economic incentive to provide financing unless a target yield is met for lenders.

The one exception would be zero-coupon bonds, which do not include any interest expense for the borrower.

Cash Flow vs. Balance Sheet Insolvent: What are the Different Types of Insolvency?

There are two distinct types of insolvency. In both, the end result is the same, but the source of the problem is different.

  • Cash Flow Insolvent → The company’s free cash flow (FCF) is inadequate to pay its debts and debt-like obligations on the maturity date.
  • Balance Sheet Insolvent → The company’s balance sheet consists of liabilities far in excess of its assets.

In either case, the insolvent company is unable to service its interest payments or repay its outstanding debts (and related liabilities).

Cash flow insolvency is usually the result of an unpredicted trigger (i.e. performing far below expectations or due to an unexpected event such as a global supply chain shortage or pandemic), whereas balance sheet insolvency stems from management neglect of downside risk and overconfidence in future profits and free cash flow (FCF) generation.

Often, the borrower raises debt capital to fund its operations and growth plans, however, lackluster results and a downward contraction of profit margins can place the borrower at risk of default.

If a borrower does not have sufficient cash on hand to pay a required interest payment or repayment of principal – either as amortization throughout the lending period or the lump sum payment at the end of the borrowing term – the company is in technical default.

Insolvent vs. Bankrupt: What is the Difference?

Insolvency or the risk of becoming insolvent is the primary reason that companies seek restructuring or file for bankruptcy protection.

Formally, insolvency is defined as the state in which the sum of a company’s debt liabilities exceeds the fair value of its assets.

Once determined to be insolvent, the company’s board of directors and management must now act in the best interests of the company’s creditors rather than its shareholders, i.e. their fiduciary duty has shifted from equity holders to creditors.

Companies that encounter financial challenges due to a sudden shortage of cash or an unexpected event can easily become insolvent, but that does not necessarily mean that they are bankrupt.

For instance, the management team of an insolvent company could hire advisors to work alongside its creditors as part of out-of-court restructuring to arrive at an amicable resolution that is acceptable for all parties involved.

But out-of-court restructuring is normally only a viable option for companies with only a handful of creditors, and the underlying issues that caused the insolvency are not dire.

In contrast, an insolvent company filing for bankruptcy implies that the debtor and creditors failed to arrive at a resolution out-of-court. Hence, the necessity for the involvement of the Court.

Therefore, insolvency can precede bankruptcies, but the two terms are not interchangeable, as temporary insolvency can be fixed without a company having to file for bankruptcy protection.

How to Measure Insolvency Risk?

Solvency ratios can gauge a company’s default risk and the likelihood of a company becoming insolvent, namely a borrower’s ability to meet its long-term financial obligations.

Not being able to pay mandatory amortization of debt, periodic interest expense payments, or the repayment of the entire outstanding debt principal at maturity are the main causes of default.

Used to measure the creditworthiness of a borrower, solvency ratios such as the D/E ratio can determine the long-term viability of a company and if its future operations appear sustainable over the long run.

In order for a company to remain solvent, the company must possess more assets than liabilities on its balance sheet and generate sufficient cash flows to fulfill all scheduled payment obligations.

How to Analyze Insolvency Risk?

The following list compiles the most common solvency ratios used to analyze the insolvency risk of companies.

Debt-to-Equity Ratio (D/E) = Total Debt ÷ Total Equity
Debt-to-Assets Ratio (D/A) = Total Debt ÷ Total Assets
Equity Ratio = Total Equity ÷ Total Assets
Capitalization Ratio = Total Debt ÷ (Debt + Equity)

Note that the ratios above are more-so measures of balance sheet insolvency (i.e. leverage risk in the capital structure).

With regard to cash flow insolvency, coverage ratios can be more useful, especially if near-term liquidity is a concern.

Interest Coverage Ratio = EBIT ÷ Interest Expense

For a longer time horizon, cash flow leverage ratios should be assessed alongside all the metrics above to determine the full picture of a company’s financial state.

Total Debt-to-EBITDA = Total Debt / EBITDA
Net Debt-to-EBITDA = Net Debt / EBITDA
Total Debt-to-EBIT = Total Debt / EBIT

Put together, the financial risk measures explained above should be enough to determine if a company’s debt burden is manageable given its fundamentals, i.e. its ability to generate cash consistently and its profit margins.

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