Quick quiz, would you rather be insolvent or illiquid? If you said illiquid it’s because you’ve heard “liquidity” in the media often and have a bias towards what you know, but insolvent is much less common and a lot people don’t really know what it means. Liquidity and solvency are terms to describe a firm’s ability to pay off their debts. To see how much debt a company has you need to look at their balance sheet, which has three categories: assets, liabilities, and equity. The fundamental accounting equation is assets = liabilities + equity. The sum of liabilities and equity must equal the assets of the company, hence the report’s name “balance sheet”.

Assets are anything the firm has than contains some kind of monetary value. It could be anything from cash to a 100 year old building. Liabilities are any debts owed. This could be anything from a credit card to bonds sold to the public. Equity is how much accounting value is left over. Note, rarely would the equity on a balance sheet equal the stock price of a company.

If a company is illiquid that means they don’t have enough cash to pay off the debts they need to pay. Some debts may not need to be paid now, so a company wouldn’t be illiquid until that is due. If all the company’s assets are tied up in a building and some inventory they can’t sell, they’re illiquid. Let me paint you a picture.

REITonomiocs is a company that invests in real estate. They have $100 in cash, $1 million in real estate, and owe $1 million in debt (note in this situation they have $100 in equity, but we’re going to ignore this). The debt is split in two loans, the first is due next week and has a balance of $500,000, the second is due in 10 years and carries the same balance. REITonomics has no cash to pay this debt and can’t sell any properties to pay it. They may be able to borrow more money to pay off the current debt, depending on their credit rating and the state of banks. So bankruptcy is a possibility, but not the only way out. Having no liquidity sucks, but being insolvent is worse.

WHEATonomics is a wheat farm in southern Illinois. The company has $100 in cash, $400,000 in wheat, a $100,000 barn, and $500,000 worth of farm equipment. Again, WHEATonomics owes $1 million, $500,000 of which is due next week. But a storm roles in and unleashes tornados that destroy the harvest, barn, and equipment. Stupid WHEATonomics didn’t buy any insurance either. They now owe $500k next week and only have $100 in assets. Bankrupcty is the only option for WHEATonomics. They are insolvent.

Solvency and liquidity have lately been used to describe companies that have struggled due to the financial meltdown. A local bank that may have had a lot of local mortgages on the books, may have had to write down their values therefore they literally ran out of assets. On the balance sheet, this would show negative equity to make the balance sheet balance. So illiquid is bad, but isolvent is much worse. Strive to remain liquid and solvent on your personal balance sheets.

Photo: neilbetter

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categories: business