Individuals and businesses often wonder what the difference between liquidation and insolvency is. Simply put, they are roughly the same, i.e. when a company is unable to pay its debts, it suffers liquidation or insolvency but in certain cases the company can have a solvent liquidation, if the business is being wound down for whatever reason. That said, there is still a difference between the two that must be understood as both these terms are super important when it comes to tax laws in the United Kingdom. So, let’s check out the nuances of both these technical terms and how exactly they differ from each other!
What Is Liquidation?
In finance, liquidation can be defined as the process through which businesses are brought to an end, and their assets are distributed to the claimants. The process of liquidation happens when a company is insolvent. Assets are often distributed on the basis of the claims of various parties involved where the trustees are appointed by the court of law.
Once the liquidation process is terminated, the business is no longer in existence. Liquidation is also a process of selling all the inventory at highly discounted rates. Therefore, in order to understand what liquidation is, it is essential to understand the meaning of “insolvency” as well.
What Is Insolvency?
Insolvency is a crucial term in the field of business and economics. It refers to a state of an organisation or an individual where it cannot meet its financial obligations any longer. This happens when they are not able to pay their debts to the lenders beyond the due date. Insolvency usually results from poor cash management, an increase in the expenses or a drastic reduction in cash inflow as per the forecasts. Usually before a company goes completely insolvent, it might indulge in informal agreements with the creditors to find alternative solutions in order to pay its debts completely.
Insolvency leads to a lot of financial distress and is a state when a business or an individual is not able to pay the bills. Legal action is taken in such cases and can also lead to insolvency proceedings by the court. Several factors lead to insolvency in a company. Some of these factors include hiring inadequate human resources or accounting management. So, if the accounting manager does not create a good budget for the company, it might result in overspending. So, if more money flows out and less money comes in, a business might become insolvent.
Another reason for insolvency is high costs for vendors. So, if a business pays higher prices for goods and services, it has to increase the prices for its customers as well. Many times, this leads to customers taking their business elsewhere so that they can pay less for similar goods or services. Hence, a loss of clientele due to this reason might also result in losing income.
Difference Between Liquidation and Insolvency
To begin with, insolvency is a financial state of being. In this state, a company is not able to pay all its debts and usually has more liabilities than it does assets when it comes to its balance sheet. In legal terms, this state is called “technical insolvency.” On the other hand, liquidation refers to a state in which a limited company comes to a legal ending. This state of liquidation prohibits a company from employing staff or doing business in the market.
In this context, it is essential to remember that a company can be technically solvent and still be unable to repay its debt. This situation takes place when a particular company or firm is “cash insolvent.” Companies with assets that are more than their liabilities also come in this category. More often than not, such companies also cannot source additional funds to repay their debts. In such a scenario, more often than not, the court of law appoints a liquidator to the company in order to administer and oversee its assets as well as distribute all the proceeds of that liquidation to the creditors of a company. The liquidator does all this following the provisions stated in the Corporations Act.
Therefore, even if a company suffers insolvency, it does not have to result in liquidation. Some companies even use a voluntary liquidation process in order to assess the value of their accumulated assets in a tax-efficient manner.
How Can We Help You?
Limelight Accountancy can be of immense help in this regard as it can help educate you regarding everything related to managing the finances of your company. If your budgeting is done well and the financial management is proper, most likely, you will not face any issues with regards to deficits and budgeting. So, you can avail the services of Limelight Accountancy and never worry about liquidation or insolvency. You can simply get in touch with us to get a free consultation and learn more about these financial matters.