Insolvency vs Liquidation: What’s the difference?

When it comes to business finance, it can be hard to understand all the jargon and technical terms. Not knowing what they mean or how they differ from one another can make it even harder to navigate your situation. Two commonly misunderstood terms that are often interlinked are insolvency and liquidation. 

In this article, we take a closer look at insolvency and liquidation to explain what each term means, how the processes work and how they are different from one another. Let’s start by understanding what insolvency is. 

What is insolvency? 

Insolvency is the financial term given to a company when its income is unable to cover its financial outgoings as and when they fall due. If a company cannot cover staff wages or pay its creditors each month, then it would be classed as insolvent.

There can be many causes of insolvency, such as poor financial management, a decline in cash inflow or a significant increase in expenses. One or all of these factors can lead to a company becoming insolvent if early action isn’t taken.   

Early warning signs of insolvency

As with any financial difficulty, taking action early can help improve the situation and often means there are more options available. Ignoring financial problems until it is too late can mean there is no choice but to wind down the company.

No one wants to admit their company is failing or has hit a rocky patch. But the sooner you recognise the signs of insolvency, the quicker you can take steps to achieve the best possible outcome for you, your business, your staff and your creditors. 

Some of the early warning signs of insolvency include: 

• Decrease in cash flow
• Reliance on overdraft 
• Increasing debt
• Delays in paying creditors or staff wages 
• Falling margins
• Demands for repayment from creditors 
• Suppliers refusing to deliver until they have received payment 

What is liquidation? 

Liquidation is a formal and legal process that effectively brings a company’s operations to a close and distributes its assets to creditors (and on occasion, its shareholders). While this process is usually the result of insolvency, that may not always be the case.

Some solvent companies may decide to voluntarily enter liquidation for strategic purposes such as changes in the market or needing to restructure the company. The type of liquidation process that is initiated will depend on whether the Liquidation is forced upon the Company by its creditors or whether the liquidation is actioned by its directors.  There is also a liquidation process for solvent companies to tax efficiently distribute their funds which is explained further below.

Types of liquidation

There are three types of liquidation; each involves the selling of company assets to repay creditors, but the processes may differ from one another. The three types of liquidation are:

1. Creditors’ Voluntary Liquidation (CVL): A CVL often takes place when a company has become insolvent and can no longer meet its financial obligations or afford to continue to operate. In this case, It is the directors of the company’s responsibility to instruct an insolvency practitioner and begin the process of placing the company into liquidation. Once this decision has been made, control of the business will then be handed over to a liquidator.  

2. Members Voluntary Liquidation (MVL): An MVL is the type of liquidation that is used for a solvent company that is still able to meet its financial duties and trade, but the directors of the company wish to close it down. Typical cases of MVL are when a director retires or when a family business has no one to take over and continue running the company, or if the business has been sold.

Just as with a CVL, once the decision has been made to enter liquidation, the process follows the same path, but instead of there being a shortfall to repay creditors, all creditors are paid and then the members receive the balance of funds as a shareholder distribution.

3. Compulsory Liquidation: This type of company liquidation occurs when a winding-up petition is issued by a creditor of an insolvent company. The reason for this action would be as a result of due debts not being settled. In the case of compulsory liquidation, the courts are involved to hear the case at a winding-up hearing. The judge can then make a winding-up order to put the company into compulsory liquidation. If this happens, a liquidator is appointed to oversee the process.  

How are insolvency and liquidation different?

Insolvency is the term applied to a company that cannot pay its debts as they fall due or the value of its assets is less than that of its liabilities. A company can also be deemed insolvent if the asset value is greater than its liabilities, but the company is unable to meet its ongoing cash flow obligations, such as paying wages or creditors. Being insolvent does not always mean that a company will enter liquidation. Early action can help turn it around. 

Liquidation is one of the legal processes for closing down an insolvent limited company. This means that the company can no longer trade or employ staff. At the end of the liquidation process, the company is formally dissolved and no longer legally exists. 

Do you need insolvency or liquidation advice?

If your company is in financial difficulty and you need affordable insolvency or liquidation advice, please contact Bridge Newland today on 0800 612 6197.

Categorised in: Insolvency Reviews & Advice