What is the Difference Between Insolvency and Bankruptcy?

It is in the realms of understanding economics and law that bankruptcy and insolvency concepts come into picture. While 'bankruptcy' and 'insolvency' are terms most often used interchangeably, these two are, however, two different states of financial distress from each other. So what is the difference between bankruptcy and insolvency? The definition of insolvency is when a person or business cannot make payments to creditors when due. It describes a financial situation where liabilities outnumber the value of assets. On the other hand, bankruptcy is a legal process under which a court declares that an individual or some other entity is unable to pay debts. It therefore gives an insolvent entity a means of getting relief about some or all their debts.

The topic what is the difference between bankruptcy and insolvency is relevant to General Studies Paper III of the UPSC Mains examination under Indian Economy. In this context, the paper deals with various economic terminologies as well as laws dealing with business environments in which the whole process regarding insolvency and bankruptcy holds utmost relevance.

What is Insolvency?

The situation where an individual or a body fails to pay the debts when and as they fall due is known as insolvency. Generalizing this would simply point out that liabilities surpass assets. It is among the very first symptoms of distress over one's finances, and there may either be a cause of insufficiency in the management of cash or due to an escalation of inflowing cash, or because of some unbudgeted expenditure. Insolvency can be either transient or chronic; if not treated at the right time, it can further become bankruptcy.

The signs of insolvency include:

• Cash Flow insolvency: The individual is not able to pay back the debts when they become due and payable even though assets are more than liabilities.
• Balance Sheet insolvency: Liabilities are greater than the assets, thus it has a negative net worth.

Read the article on the Insolvency and Bankruptcy Board of India (IBBI)!

What is Bankruptcy?

Bankruptcy is a status conferred by a court. It refers to a process in which an insolvent individual or legal entity takes the initiative to declare the inability to pay debts. The process in a bankruptcy case involves inspection by the court and quite often it forms the basis of fair and equitable distribution of debt to be paid among the creditors. In the majority of countries, speaking generally, bankruptcy laws finally result in either liquidating or rehabilitating the business.

Major steps carried out in bankruptcy include:

• Voluntary Bankruptcy: The debtor initiates the process and seeks relief from debt.
• Involuntary Bankruptcy: The creditors start the process by filing a petition against the debtor.
• Bankruptcy Decision: This could either be in the liquidation of assets to pay debt or reorganizing debt obligations to ensure continuation of business.

Read the article on the Insolvency and Bankruptcy Code (Amendment) Bill, 2020!

What is the Difference Between Insolvency and Bankruptcy?

To understand these terms clearly, it becomes important to distinguish between the two concepts. The following table captures the significant differences:

Read the article on the Changes in Insolvency Act!

Conclusion

This distinction between insolvency and bankruptcy will act as a premise of understanding financial distress and how the law steps into action. Financial bankruptcy refers to the first stage, a state of insolvency whereby liabilities outweigh the assets. Bankruptcy is a judicial process intended to obtain debt relief by liquidating some of a debtor's assets or readjusting obligations that a creditor has against the debtor. It plays a very central role in the prevention of economic bankruptcy and to facilitate creditors and debtors' management during financial collapse.

Read the article on NBFCs & IBC!

We hope your doubts regarding the topic have been addressed after going through the above article. Testbook offers good quality preparation material for different competitive examinations. Succeed in your UPSC IAS exam preparations by downloading the Testbook App here!