Bankruptcy and Insolvency of a Business

TITLE: Bankruptcy and Insolvency of a business 

INTRODUCTION

This report clarifies the term bankruptcy and insolvency, outlines the main causes of the insolvency and explains the importance of cash management to avoid insolvency.

BODY

What are insolvency and bankruptcy?

Insolvency is a financial state of being a company becomes insolvent when they are unable to pay off their total debts back on time. So, they may choose to declare bankruptcy when they encounter insolvency. Bankruptcy is the legal declaration of one’s inability to pay its debts out of its current assets.

The main causes of insolvency

There are two aspects of reasons which are external and internal reasons.

• External reasons

1. The reason may be the whole economic condition experience a recession stage of business cycle which means the business would earn less revenue since the pessimistic expectation of consumer, so they prefer to save money. Lower cash inflow would result in the business get insufficient cash reserve to cover debts which means business getting worsen in liquidity problem.
2. Poor customer service may let consumer loss confidence on the business, so they may prefer to choose competitor’s services who provide a better service that would decrease demand for the business and the sales decrease directly. Therefore, business may not have enough cash reserve to pay debts which means liquidity problem is compounded by lower sales revenue.

• Internal reasons

1. Business lack of capital or funds to keep business operating may be one of internal reason since the business get insufficient funds to buy stock for sale which means the business earn less. It would result in the cash reserve getting lower and not enough to pay debts.
2. Poor financial management may be another internal reason. Effective cash management is an essential part of financial management. Poor cash management is the prime reasons for failure of many small businesses. A business with poor cash management will usually have liquidity problem which is difficulty in paying its debts as they fall due (Fair, 2010).

The importance of cash management to avoid insolvency

A better cash management is good for avoiding insolvency. It need to based on information of Cash Flow Statement and Cash Budget Statement. These information use to manage short term and long term business activity to ensure the liquidity of the business.

• For short term situation, cash flow statement gives stakeholders a great deal of information about the liquidity and performance of the business by identifying whether the business is making enough from operating activities and giving creditors information about the ability of the business to meet its debt payment. These information help managers consider do they need to change strategy or decision for increasing cash receivable to ensure the business have enough cash reserve to pay debts which could avoid insolvency (Prose,1983).

• For long term situation, Statement of Cash budget estimate what cash flows are expected to occurs in a future time period. It is used to plan future activities and highlight potentially cash shortage in advance allow management to take steps to avoid cash shortage, plan ahead for these time, reset a company’s priorities, or making a new investment for future projects which could increase potential benefit in order to have more cash reserve ensure the ability to pay debts in the future (Fiore, 2005).

Conclusion

This repot has clarified the term of bankruptcy and insolvency, outline the main reasons of insolvency and explained the essential role of cash management to avoid insolvency. Thus, it can be concluded that the cash management is a key component of ensuring a company’s financial solvency.