Investors examine a variety of aspects while making investment decisions in a company. Profits are the most important since they can affect investors’ future returns. However, if a corporation has cash flow issues or operational inefficiencies, its earnings may be meaningless.
It is critical to distinguish between illiquidity and insolvency. The difference between these two terms can be difficult for some people to understand because they are often used interchangeably by the media and general public without any distinction. Insolvency is the antonym of solvency, while illiquidity is the antonym of liquidity.
What is Illiquidity?
Before diving into the illiquidity vs. insolvency debate, it is critical to define liquidity to comprehend illiquidity. Liquidity refers to a company’s capacity to fulfill its current liabilities with its existing assets. A corporation’s liquidity indicates if it has enough cash on hand to pay down all of its current liabilities without resorting to long-term investments.
In order to understand this concept further, we need to look at the difference between liquid assets and illiquid assets. Liquid assets are those that can be easily converted into cash in a short time frame. Illiquid assets are those that cannot be converted into cash as easily as liquid assets and require more time or effort in order to do so.
The term “liquidity” is frequently used to refer to a company’s money flow and working capital management. The polar opposite of liquidity is illiquidity. Illiquidity occurs when a company’s existing assets are insufficient to cover its current liabilities. An Illiquid company is unable to meet its financial obligations in a timely fashion. This is typically caused by the lack of sufficient cash or other liquid assets.
Illiquid businesses may experience financial difficulties in the future. Typically, these businesses must rely on securing financing or internally generating assets to meet their needs.
Investing in companies with liquidity problems is frowned upon by investors. The liquidity of an investment indicates how easily it may be converted into cash for investors. As a result, investors can rapidly acquire some money when a highly liquid investment is compared to an illiquid one. Investors will typically find it easier to convert an active market investment into cash. Stocks, for example, are something they may trade on stock exchanges. They could also be made up of easily convertible government bonds.
What are liquidity and credit risks?
Liquidity refers to the ability to turn an asset into cash swiftly. Liquidity risk occurs when an investor cannot turn an investment into cash fast or without incurring significant loss in the value of the asset.
Credit risk refers to a borrower’s ability to make timely payments, resulting in a loss. Analyzing a borrower’s financial strength can disclose whether they will make future payments. The borrower’s financial statements, financial history, present financial status, investment exposure, and ability to raise funds are all examined during this process. Credit ratings may exist for some borrowers, such as major corporations.
What is Insolvency?
Insolvency is the inability to pay one’s debts as they come due. Insolvency is a state of financial crisis in which a company cannot satisfy its obligations. Insolvency typically arises due to inadequate cash flow, excessive debt, or both. Insolvencies are so serious that some people describe them as a “bankruptcy in slow motion.” Insolvency can lead to the company’s eventual liquidation or legal action.
Difference: Illiquidity Vs. Insolvency
Illiquidity means when a company’s existing assets are insufficient to cover its current liabilities. On the other hand, insolvency occurs when a company’s total assets are less to cover its total liabilities. The investor requires funds to make debt payments and does not have any other assets to trade. As a result of the liquidity risk, the investor will become insolvent.[wptb id=2162]
Can illiquidity lead to insolvency?
What happens if an investor discovers that their investment is vulnerable to illiquidity? Will the risk of being insolvent automatically arise. An illiquid company will not automatically become insolvent. It is at a higher risk towards insolvency and may become insolvent and bankrupt. But it may also recover and succeed in converting its illiquid assets into liquid assets and becoming stable.
To go over these numerous scenarios, we’ll utilize a few instances.
- The investor has no other assets except the primary one to sell and raises cash to meet debt obligations. If the investor sells the item right away, it will lose 25-30% of its value, not enough to pay off the debt. In this instance, the investor will not only be late on payments, but they will also be unable to pay off the entire loan even after selling the investment (at a discount). As a result of the liquidity risk, the investor will become insolvent.
- In a similar case, we’ll utilize the same investor. The investor owns a financial asset that provides enough monthly income to cover their debt payments. Although the investor works, he spends all his earnings on living expenses, so he has no liquidity. This investor is however regularly paying his debts and will not become insolvent.
- The investment company has a single customer who accounts for 75% of its revenue. The customer chooses a different vendor due to a change in qualifying criteria. However, if the investor has no big debts, it can stay afloat till it finds new customers.
Dealing with Insolvency
Companies in financial distress lack the requisite income and cash flow to meet their operating and debt obligations. These businesses must find ways to boost their net income and cash flow from operations by raising revenue or cutting costs. If the company cannot improve its operations, its debt burden will become too enormous, forcing it to declare bankruptcy.
We hope the difference between Illiquidity & Insolvency is apparent to you, and you wont confuse these deceptively similar terms now. Do check the difference between two more often confused terms: capital and revenue.