Building Your Business Operations & Success Why Do Businesses Go Bankrupt? By Jean Murray Updated on September 19, 2022 Fact checked by Mrinalini Krishna In This Article View All In This Article What is Business Bankruptcy? Bankruptcy and Insolvency What Causes Insolvency and Bankruptcy? Getting Help to Avoid Bankruptcy Frequently Asked Questions (FAQs) Photo: pixelfit / Getty Images Business bankruptcy means a business is insolvent and unable to pay off its debt. According to data from the U.S. Courts, more than 22,000 businesses went bankrupt every year from 2016 to 2020. This statistic doesn't include the number of small businesses that just close their doors and walk away from their failing businesses. But what causes insolvency? The answer is complex, but it usually boils down to failures of management, marketing, and finances. Key Takeaways Business bankruptcy is a legal process that allows troubled businesses to pay back creditors and get a new startBusinesses file bankruptcy because they are insolvent, unable to pay their bills in both the short term and long termThe basic causes of insolvency are failures of management, marketing, and financial aspects of a businessA business may also fail from external causes What is Business Bankruptcy? Business bankruptcy is about debt. A business becomes bankrupt when it can no longer pay its bills and there is no chance of being able to take on more debt to pay them. Bankruptcy is a process run by U.S. bankruptcy courts that helps businesses and individuals who can no longer pay their debts an opportunity for a fresh start. The three types of business bankruptcy processes are: Chapter 7 liquidation, sale of business assets and closing the business Chapter 11 reorganization, a process overseen by a trustee to keep the business alive and pay creditors over time Chapter 13, adjustment of debts for business assets tied to personal assets, allowing the debtor to pay off debts while keeping certain assets (Chapter 13 bankruptcy) Note A business can fail (go out of business) without declaring bankruptcy. The causes of business failure are the same as the causes of bankruptcy. Bankruptcy and Insolvency Bankruptcy at its core involves the inability of a business to pay its debts, a situation called insolvency. The solvency of a business relates to leverage, the ratio of the value of business debts to its assets. The higher the leverage, the more debt in relation to assets. Here’s an example of the effect of leverage on business bankruptcy: During the early years of the COVID-19 pandemic, bankruptcies were most common in smaller businesses with higher leverage. Solvency is difficult to define, and it varies by industry and individual situations, but in general, it involves both short-term and long-term situations: Cash flow insolvency: The business can’t pay its debts as they come due in the course of business in the short termBalance sheet insolvency: The business’s assets (the things of value it owns) are greater than its liabilities (debts), resulting in negative assets in the longer term Note A business may be insolvent without becoming bankrupt, but insolvency is often a necessary condition for bankruptcy. A bankruptcy court makes the decision to grant bankruptcy status based on individual circumstances. What Causes Insolvency and Bankruptcy? There are many theories about the root causes of insolvency, business failure, and business bankruptcy, but most theories boil down to three: poor management, poor marketing, and poor financial practices. Management, Marketing, and Financial Causes Many people go into a small business with technical expertise in their field and management experience within a company, but small business management is a different skill set. It requires wearing many different hats and juggling the demands of different groups (employees, customers, vendors, and regulators). In many cases, the failure of a small business rests on the poor decisions of its owner in management, marketing, and finances. Poor decision-making at startup often results in undercapitalization, which means the company doesn’t have enough assets, especially cash, to conduct business on a day-to-day basis. Not getting enough capital for a startup starts a downward spiral that’s difficult to overcome, because the business goes further and further into debt to get working capital for day-to-day operations and loans to buy needed assets. Other Causes of Bankruptcy The rate of bankruptcies in the U.S. can also be affected by external factors. For example, the number of bankruptcies dropped by almost 30% in 2020 because many courts limited public access during the first year of the COVID-19 pandemic. Note Statistics on bankruptcy filings may be misleading because they don’t include the numbers of businesses that sell assets privately and close their doors. Some external factors that disrupt businesses and may lead to bankruptcy might be: Changing economic conditions, like increases in competition, and increased costs of doing business Personal issues, like illness or divorceCalamities, like theft, natural disasters, or accidentsDisputes with a creditor or tax issues Getting Help to Avoid Bankruptcy If your business is struggling, get help from your banker, attorney, and licensed tax professional to attempt to turn it around. You might even want to talk to a bankruptcy attorney to see if you qualify for bankruptcy. Frequently Asked Questions (FAQs) What happens to a business when it goes bankrupt? The business bankruptcy process begins by filing a petition with a bankruptcy court. If the court grants the petition, the business begins the process of paying back creditors. It may liquidate by selling all its assets and paying creditors. Another option is to reorganize under the direction of a bankruptcy trustee, with a plan to pay creditors while continuing do be in business. Can a profitable business go bankrupt? Making a profit doesn’t guarantee that your business will avoid bankruptcy, because you can show a profit and not have enough cash to pay your bills. For example, you may have lots of sales but you also have lots of accounts receivable, money owed to you by customers, and you still have to pay your employees and vendors, and pay back loans for supplies. If you continue to have cash shortfalls, you may need to add more debt to the point where you don’t have enough cash to pay all your creditors. That situation can cause business failure or bankruptcy. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. U.S. Courts. "Annual Bankruptcy Filings Fall 29.7 Percent.” Don B. Bradley III and Chris Cowdery. “Small Business: Causes of Bankruptcy. U.S. Courts. "Bankruptcy." Cornell Law School Legal Information Institute. “Liquidate.” U.S. Courts. "Chapter 11 – Bankruptcy Basics.” U.S. Courts. "Chapter 13 – Bankruptcy Basics." Federal Reserve Bank of Boston. " The Great Leverage 2.0? A Tale of Different Indicators of Corporate Leverage." Federal Reserve Bank of Boston. "Review of U.S. Business Bankruptcies During the COVID-19 Pandemic (PDF Download)." Cornell Legal Information Institute. "Insolvency.” Cornell Law School Legal Information Institute.”Undercapitalization."