But what causes insolvency? The answer is complex, but it usually boils down to failures of management, marketing, and finances.
What is Business Bankruptcy?
Business bankruptcy is about debt. A business becomes bankrupt when it can no longer pay its bills and there is no chance of being able to take on more debt to pay them. Bankruptcy is a process run by U.S. bankruptcy courts that helps businesses and individuals who can no longer pay their debts an opportunity for a fresh start. The three types of business bankruptcy processes are:
Chapter 7 liquidation, sale of business assets and closing the business Chapter 11 reorganization, a process overseen by a trustee to keep the business alive and pay creditors over time Chapter 13, adjustment of debts for business assets tied to personal assets, allowing the debtor to pay off debts while keeping certain assets (Chapter 13 bankruptcy)
Bankruptcy and Insolvency
Bankruptcy at its core involves the inability of a business to pay its debts, a situation called insolvency. The solvency of a business relates to leverage, the ratio of the value of business debts to its assets. The higher the leverage, the more debt in relation to assets. Here’s an example of the effect of leverage on business bankruptcy: During the early years of the COVID-19 pandemic, bankruptcies were most common in smaller businesses with higher leverage. Solvency is difficult to define, and it varies by industry and individual situations, but in general, it involves both short-term and long-term situations:
Cash flow insolvency: The business can’t pay its debts as they come due in the course of business in the short termBalance sheet insolvency: The business’s assets (the things of value it owns) are greater than its liabilities (debts), resulting in negative assets in the longer term
What Causes Insolvency and Bankruptcy?
There are many theories about the root causes of insolvency, business failure, and business bankruptcy, but most theories boil down to three: poor management, poor marketing, and poor financial practices.
Management, Marketing, and Financial Causes
Many people go into a small business with technical expertise in their field and management experience within a company, but small business management is a different skill set. It requires wearing many different hats and juggling the demands of different groups (employees, customers, vendors, and regulators). In many cases, the failure of a small business rests on the poor decisions of its owner in management, marketing, and finances. Poor decision-making at startup often results in undercapitalization, which means the company doesn’t have enough assets, especially cash, to conduct business on a day-to-day basis. Not getting enough capital for a startup starts a downward spiral that’s difficult to overcome, because the business goes further and further into debt to get working capital for day-to-day operations and loans to buy needed assets.
Other Causes of Bankruptcy
The rate of bankruptcies in the U.S. can also be affected by external factors. For example, the number of bankruptcies dropped by almost 30% in 2020 because many courts limited public access during the first year of the COVID-19 pandemic. Some external factors that disrupt businesses and may lead to bankruptcy might be:
Changing economic conditions, like increases in competition, and increased costs of doing business Personal issues, like illness or divorceCalamities, like theft, natural disasters, or accidentsDisputes with a creditor or tax issues
Getting Help to Avoid Bankruptcy
If your business is struggling, get help from your banker, attorney, and licensed tax professional to attempt to turn it around. You might even want to talk to a bankruptcy attorney to see if you qualify for bankruptcy.
