Illiquidity and insolvency are both terms used to describe a business that is dealing with cash flow problems or operational inefficiencies. But they actually have different meanings. Illiquidity is when a company does not have enough current assets to meet its current liability obligations. Insolvency, on the other hand, is when a company does not have enough total assets to satisfy its total liabilities.
As a small business owner, it’s important to understand the difference between insolvency and illiquidity, how insolvency can lead to illiquidity, and what you can do to remedy either problem and get your business back on the road to financial health.
What Is Illiquidity?
To understand illiquidity, it helps to understand liquidity. When a company has liquidity, it means it has the ability to pay its current debt and liability obligations with its current assets. It does not need to liquidate any of its long-term assets to pay its short-term liabilities. Liquidity is a term often associated with a company’s cash flow and working capital management.
Current liabilities may include:
• Accounts payable
• Bills/utility payments
• Loan payments
• Taxes
Current assets may include:
• Accounts receivable
• Cash
• Inventory
• Securities: stock, treasury bills, or any security that can easily be sold
The opposite of liquidity is illiquidity. When a company is illiquid, it does not have the ability to pay its current liabilities with its current assets. If not remedied, illiquidity can lead to more serious financial problems in the future, including insolvency.
How Does Illiquidity Work?
A business that is illiquid is generally facing short-term cash flow issues. Its future is not necessarily in question, but it could be. The good news is that a business owner can often solve any issues with illiquidity by providing more capital, getting a small business loan or line of credit, and/or restructuring the company’s operations.
Recommended: What Is Trade Working Capital?
What Is Insolvency?
To understand insolvency, it helps to understand solvency. When a company is solvent vs insolvent, it means that its assets are worth more than its liabilities and it can meet its long-term debt obligations without any trouble. If a business is unable to cover all of its debts (even if it liquidated all of its assets), it is considered insolvent. Financial solvency is essential for the long-term survival of any business.
How Does Insolvency Work?
When a business is insolvent, it means that the owners’ (or shareholders’) equity, which is the company’s assets minus its liabilities, is negative. While it’s not uncommon for new small businesses to have negative owners’ equity on the balance sheet, solvency typically improves as a company matures.
However, businesses can also move in the wrong direction, going from solvent to insolvent. This can happen for many different reasons, including poor cash management, a reduction in cash inflow, an increase in expenses, lawsuits, and/or not adapting to changes in the marketplace.
Insolvency can lead to bankruptcy. It can also lead to insolvency proceedings, in which legal action is taken against the insolvent business and its assets may be liquidated to pay off outstanding debts.
Insolvency vs Illiquidity Compared
Illiquidity and insolvency have similarities, but also some key differences. Here’s how they compare.
Similarities
Both illiquidity and insolvency:
• Are forms of financial distress
• Occur when a company is unable to pay upon its debts because of a shortage of assets
• Represent an immediate problem that must be addressed
• Can lead to bankruptcy (although insolvency is more serious)
• Can be solved
Differences
Here’s a look at how liquidity and insolvency differ:
• Illiquidity is a short-term problem; insolvency is a long-term problem
• Illiquidity is when a company doesn’t have enough in liquid assets to cover its current debts; insolvency is when a company’s overall debt exceeds its total assets.
| Insolvency | Illiquidity | |
|---|---|---|
| Suggests cash flow issues: | ✓ | ✓ |
| Is a short term problem: | X | ✓ |
| Is a long term problem: | ✓ | X |
| Not enough assets to cover debt obligations: | ✓ | ✓ |
| A company may have enough in illiquid assets to cover its liabilities, but selling them is not ideal: | X | ✓ |
| Requires immediate action: | ✓ | ✓ |
| May lead to bankruptcy: | ✓ | ✓ |
Dealing With Liquidity Issues
If your business is in a state of illiquidity, you may be able to prevent insolvency by taking some of the following steps.
• Sell off unproductive assets. Any asset that is not generating cash flow isn’t doing your business any good. Consider selling any idle machinery, unused computers, or rarely used vehicles.
• Reduce overhead costs wherever possible. You may be able to improve cash flow by reducing how much you spend on marketing, subscriptions, and any other indirect expenses.
• Be aggressive with accounts receivable. Don’t let customers go months on end without paying their invoices. Call and/or send reminder emails to get them to pay sooner.
• Look into a line of credit. A business line of credit might help you cover gaps in cash flow due to payment schedules.
• Consider refinancing your debt. This could lower your monthly bill. However, it may mean paying more in interest over the long run.
• Consider invoice financing: Invoice financing can help solve short-term cash flow problems by providing immediate payment for your unpaid invoices (in exchange for a fee).
When Does Illiquid Become Insolvent?
If a company is unable to solve its cash flow issues (either by liquidating once illiquid assets, or raising capital internally or externally), that company could easily become insolvent.
If your business’s operating performance struggles for a prolonged period of time, and your short- and long-term cash inflows are no longer able to meet your financial obligations, the company could become insolvent. This means that its total debt has become larger than its total assets and you would not be able to cover your obligations even if you sold off all of your assets.
Dealing With Insolvency
Moving a business from insolvency to solvency typically entails managing your debt and improving your cash flow. Here are some steps you can take.
• Attack your debt. List all of your company’s debts in order of priority. Focus on debts that need to be paid immediately (such as those that could interrupt operations or lead to legal trouble if not paid on time) first.
• Follow up on unpaid invoices. Be sure to collect on any money that is due to your business.
• Reach out to your creditors. If you explain your current situation, they may be willing to restructure your debt to make your payments more affordable.
• Find ways to decrease spending. Cut out all unnecessary costs and also look for cheaper suppliers for materials, stocks, and/or insurance.
• Boost your customer base. Try to increase sales by using customer feedback, increasing social media and email marketing, and learning from other businesses.
Recommended: Solvency vs Insolvency
The Takeaway
Illiquidity is when a company lacks the appropriate amount of liquid assets to pay its current obligations and debts. It can happen for many reasons, and does not necessarily mean a business is in long-term trouble.
Insolvency is when a company lacks the proper amount of assets (liquid or illiquid) to cover its debts and liabilities. In terms of financial distress, it is much worse to be insolvent than it is illiquid.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
Is liquidation the same as insolvency?
No. Liquidation is when a company sells its assets to pay off its debts. Liquidation is often done in response to insolvency, which is when a company’s debts exceed its total assets.
Can a company be solvent but illiquid?
Yes. A company can be solvent, meaning its assets are greater than its total liabilities, but not have enough cash or easily liquidated assets to pay its short-term debts and obligations. Sometimes companies solve this issue by being more aggressive with their account receivables, or by turning to invoice financing.
What are liquid and illiquid assets?
A liquid asset is an asset that can easily be converted into cash in a short amount of time. An illiquid asset is an asset that cannot easily and readily be sold or exchanged for cash.
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