Is Insolvency The Same As Liquidation?

“Insolvency” and “liquidation” are often talked about in similar contexts, leading many people to ask the question “is insolvency the same as liquidation?”. The two terms often crossover making it understandable how confusion arises, however insolvency and liquidation are in fact two different concepts.  Whilst a company that is insolvent will often enter liquidation, a liquidation can also be used to wind up companies that are still solvent. In order to clearly answer the question “ is insolvency the same as liquidation”, it’s important to start by explaining the meaning of both terms properly.

What Is Insolvency?

Insolvency refers to a state of financial distress in which a company is unable to pay their bills as and when they fall due. There are a number of reasons why a company might become insolvent. External factors, such as a financial crisis can sometimes be the cause, however it’s often internal forces, such as poor cash flow management that leads to a business becoming financially distressed. There are two main types of insolvency. These are:

Cash Flow Insolvency: This occurs when a company does not have the necessary cash to pay their liabilities. The company may have plenty of assets, but not the appropriate funds i.e cash to pay their bills as required. This means that it’s not unusual for a business that is cash flow insolvent to be asset rich but cash poor. 

Balance Sheet Insolvency: On the other hand, if a business is asset poor, and their liabilities outweigh their assets then they could be facing balance sheet insolvency. This can be determined by looking at all of the company’s assets in detail, and comparing them to their liabilities, including contingent and prospective liabilities. If there are more liabilities than assets, then the company is insolvent. 

What Is Liquidation?

Liquidation is the process of bringing a company to a close, and distributing the assets to the necessary parties involved. This process is commonly triggered by a company becoming insolvent, which is why people often ask the question “is insolvency the same as liquidation”. If a company cannot pay its liabilities, then it is their duty to prioritise the interests of creditors, and take the necessary steps to repay them what they are owed. Often the most efficient way of doing this is by liquidating company assets and winding up the affairs of the company. There are two types of liquidation that a company may face when insolvent. These are:

Creditors Voluntary Liquidation (CVL): A CVL is a sensible path forward for companies that cannot pay their liabilities as it removes creditor pressure quickly whilst ensuring that all affairs are wound up correctly, and that statutory entitlements can be claimed. In order for this process to be initiated, 75% of shareholders must vote in favour of it.

Compulsory Liquidation: If a company becomes insolvent, and does not enter voluntary liquidation themselves, then a creditor may issue a Winding Up Petition, that if granted will force the company to be liquidated. In order to prevent this, directors should be proactive in addressing their company’s financial situation. Voluntary liquidating the business will reduce the risk of allegations of wrongful trading being made against directors, whilst demonstrating to creditors that they are being proactive in prioritising their interests.

Liquidation may also occur if a business is solvent. This is why the answer to the question “is insolvency the same as liquidation” is “no”. Insolvency may lead to liquidation, however a company that is still solvent may actively choose to enter voluntary liquidation. This may be the case if the directors are looking to retire, or if the company has simply run its course. The process for the winding up of solvent companies in this way is known as a Members Voluntary Liquidation (MVL). This is a tax efficient way of extracting cash and assets whilst ensuring that all loose ends have been tied up correctly with full HMRC clearance. 

If you have any further questions regarding the topic of “is insolvency the same as liquidation”, or if you are considering liquidating your own company, please don’t hesitate to get in touch with our experienced team of licensed insolvency practitioners today.