Understanding Insolvency Risk: What Every Business Should Know
Since 48% of businesses fail within five years of beginning operations, insolvency is a very real risk for companies to contend with.
Luckily, mitigating insolvency risk is easier than ever before. Read on for a complete guide to financial instability factors and how you can prevent them.
Defining Business Insolvency
Insolvency happens when a business cannot pay back its debts in a defined timeframe. Simply put, it is a state of economic duress.
This hardship means the business has more debts and liabilities than its company value.
Insolvency risk refers to the likelihood of a business becoming insolvent in the near or distant future. Risk factors include poor management of funds, disorganized economic processes, unforeseen market changes, poor projections, and client failure.
Insolvency vs. Bankruptcy: Are They the Same Thing?
Insolvency may sound similar to bankruptcy, but they are distinct. Insolvency is a financial state rather than a legal process.
An insolvent business does not have the funds needed to pay its debts but has not yet declared legally that it cannot pay its creditors. This legal declaration would constitute bankruptcy.
However, business insolvency is often the first step toward bankruptcy. Unless businesses can quickly implement insolvency risk strategies and get their businesses back on track, they may need to file for bankruptcy. This may mean liquidating assets and shutting down the company.
Insolvency Risk Factors
There are several financial instability factors that contribute to insolvency. The primary one is poor cash flow. If a business has more money going out to creditors, suppliers, and other entities than it has coming in, it may have trouble paying back debts.
Cash flow frequently suffers because the business has failed to conduct appropriate market research and make realistic projections. In some cases, this is due to poor information on emerging economies.
Regardless, bad predictions are a recipe for unforeseen losses of income. The company will not meet its targets and, therefore, will not bring in enough money to cover expenses made with an unrealistic, poorly predicted budget.
Sometimes, lower cash inflow may become an issue even if projections are well-made. For example, unforeseen market changes can result in poor cash flow. New competitors, technological innovations, and lower demand can create issues.
Too Many Expenses
Thoughtful businesses come up with budgets every quarter. They hire professionals to look into market changes, demand, competition, clients, expenses, withdrawals, and more.
However, poor planning or an unpredictable market can lead to this budget failing. In these instances, your business may not garner the funds needed to pay creditors and stay out of debt.
Increased competition and unpredictable markets aren't the only reasons a business may have too many expenses. Sometimes, the operating expenses will shift because other markets fail. Inflation can also greatly change operating costs, so it's critical to be aware of rising prices from suppliers, shipping fulfillment facilities, and other sources.
Client Failure
Businesses rely on a plethora of clients to help them operate. When a client fails, they are unable to provide services to the company. This may mean that the business cannot access income, goods, and services needed for its operations.
As a business owner, client failure can lead to your business having a high insolvency risk through no fault of your own. You won't be getting predictable income from clients and may lose access to services you need to operate.
Some risks of client and supplier insolvency include:
- Consistently late invoice payments
- More arguments about billing with clients/suppliers
- Loss of major clients/suppliers, usually suddenly
- A desire to renegotiate contracts
- Problems paying employee salaries
Even if this does not directly lead to insolvency, it will increase operating expenses. You'll be at a higher risk of not being able to pay back debts in the future.
Unforeseen Circumstances
Personal circumstances can also cause insolvency. Some unpredictable risk factors include CEO/CFO illness, the death of important company figures, a loss of clients in large quantities, unexpected buyouts, and employee turnover.
Mass-scale circumstances can also lead to an inability to pay back debts. The COVID-19 pandemic shut businesses down for months, and when they reopened their doors, they may have lost clients and suppliers due to illness or an unstable market.
After COVID-related aid ended, 20% more businesses declared bankruptcy than during the pandemic. Also, remember that not all insolvent businesses file for bankruptcy. The economic crunch can be detrimental.
Mitigating and Managing Insolvency Risk
Catching possible insolvency early is the first step towards mitigating risk. Keep an eye out for common warning signs that you need to take action. Some of the most common include:
- Consistently lower profits
- Issues with cash flow and liquidity
- Failing book value
- Weakening balance sheets
Monitor capitalization vigilantly. Review your profits and debt regularly. Inform yourself about economic conditions in sectors related to yours.
All of these factors can help you avoid excessive debt.
Invest in Trade Credit Insurance
Trade credit insurance (TCI) is also sometimes called "accounts receivable insurance" or "export credit insurance." "Debtor insurance" is a clearer term for most businesses to understand. It protects a business if it becomes unable to pay for goods, services, and previously acquired debts.
This is because these insurers reimburse companies when customers cannot pay due to insolvency.
This means that businesses can feel more confident about extending credit to customers. They'll get their funds back even if the customer or client cannot pay their debts. This insolvency prevention method stops businesses from assuming unnecessary risks, so they don't need to worry about client-related problems creating economic duress.
Domestic credit insurance protects sales that a US business makes in the United States, Puerto Rico, and Canada. Export Credit Insurance is important for global businesses or those expanding to other countries. It protects sales to most countries worldwide.
Regardless of your needs, you can expand sales, grow your market share, and avoid catastrophic losses because of unforeseeable events.
Combat Financial Instability Factors
Now that you know how to mitigate insolvency risk, it's time to invest in trade credit insurance for your business.
ARI Global is committed to offering the best Accounts Receivable Insurance to decrease your likelihood of insolvency and bankruptcy. Get an insurance quote today to learn how we can help.