Technical Bankruptcy

Entities that are effectively bankrupt, from a practical point of view, but not legally bankrupt

What is Technical Bankruptcy?

Technical bankruptcy refers to a situation where an individual or entity (such as a corporation) is financially insolvent – has defaulted on debt payments – but neither they nor their creditor(s) has yet moved to file formal bankruptcy. In other words, they are effectively bankrupt, from a practical point of view, but not legally bankrupt.

 

Technical Bankruptcy

 

Technical bankruptcy may be eventually followed by either formal, legal bankruptcy proceedings, or financial or business reorganization or restructuring.

The phrase technical bankruptcy is also used in an entirely different context. It describes the state of a company that is operating its business with outdated software programs – commonly known as legacy platforms.

 

Summary

  • Technical bankruptcy refers to a situation where an individual or entity (such as a corporation) is financially insolvent – has defaulted on debt payments – but neither they nor their creditor(s) has moved to initiate formal bankruptcy proceedings.
  • In recent years, debt restructuring has become more common and bankruptcy filing less common.
  • Technical bankruptcy may also refer to situations where a company has allowed its IT systems to deteriorate to the point where they may need to be replaced wholesale.

 

What Leads to Technical Bankruptcy?

A state of technical bankruptcy usually results from the reluctance of the financially insolvent party or their creditors to initiate bankruptcy proceedings in hopes of finding a more acceptable solution to financial problems.

Filing for bankruptcy, while it provides the debtor with protections against garnishment, harassment by bill collectors, and eviction proceedings, carries significant disadvantages. For example, it has an immediate and substantial negative impact on the debtor’s credit rating. In the case of a business, it nearly always means the functional end of the business operating. Individuals who have virtually no assets may see little benefit in bothering to file bankruptcy and see it, instead, primarily as just another expense they can’t afford.

Because of the extreme potential negative impact of filing for bankruptcy protection, it has become more commonplace, especially for businesses, to look for a debt restructuring plan that will enable the business to continue operating. Debt restructuring plans offer the opportunity to reduce and/or renegotiate existing debt so that the debtor can regain a state of financial liquidity and continue functioning. Debt restructuring or business reorganization is also often less expensive than filing for bankruptcy.

 

Different Types of Financial Insolvency

In order to better understand technical bankruptcy, it helps to have a firm understanding of financial insolvency. Insolvency is the general state of being unable to pay your debts. Beyond that, it is typically classified as being either cash-flow insolvent or balance sheet insolvent.

 

1. Cash-flow insolvency

Cash-flow insolvency is considered the less severe form of insolvency. It is essentially a problem of liquidity. The individual or entity facing a situation of cash-flow insolvency may well have sufficient assets to pay off all of their existing debt obligations but merely lack the necessary cash to make debt payments that are currently due.

The root of the problem may be assets that are difficult to readily convert to cash or a typical and usually temporary cash flow problem resulting from something such as the slow collection of accounts receivable.

 

2. Balance sheet insolvency

The more serious and threatening type of insolvency is balance sheet insolvency. Balance sheet insolvency goes beyond mere cash flow problems and occurs when the debtor does not possess sufficient assets to cover their total liabilities. However, even in a situation of balance sheet insolvency, negotiations with creditors may still enable the debtor to remain operational and eventually return to solid financial ground.

 

Technical Bankruptcy as Bankrupt Technology

The alternate definition of technical bankruptcy describes an extreme situation that arises when, over time, a company allows its key operational IT and software systems to become so outdated that they are virtually non-functional.

The “bankruptcy” aspect of such a situation refers to the fact that the situation may have deteriorated to the point where it would be less expensive to implement a whole new system than repair the existing one.

The above type of technical bankruptcy is usually caused by management’s failure to recognize the importance of specifically budgeting for regular upgrades to a company’s IT systems. Many company executives are prone to continually opting for the quickest and least expensive solution when problems with the company’s IT systems arise.

For example, the head of IT may recommend transitioning to a new platform when adding a new feature to the company’s website. However, the top floor executives may decide they don’t want to spend the extra money that would require, so they don’t approve the expense. The problem is that if that attitude persists, you’re likely to eventually end up with a patchwork of IT systems that is difficult to sync and maintain, and, in the end, likely to crash altogether at some point.

 

Learn More

CFI is the official provider of the global Certified Banking & Credit Analyst (CBCA)™ Program, designed to teach you all the knowledge and skills required to become a skilled credit analyst. The following CFI resources will be helpful in furthering your financial education and advancing your career:

  • Chapter 11 Bankruptcy
  • Liquidity Event
  • Solvency
  • US Bankruptcy Code

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