Nonidentical Twins: Solvency and Liquidity

“It’s not a solvency problem; it’s a liquidity problem.”? So many people say regarding some financial firms that are on the ropes.? I’ve never liked that way of expressing the problem.? Let me explain why.

When does a firm typically default?? When they run out of liquidity.? True, some firms voluntarily file for bankruptcy when they see that their assets are worth less than their liabilities, and don’t see any way out.? Some firms are forced to file for bankruptcy when they trip a debt covenant.? But most firms that find their net worth slouching into, or slouching deeper into negativity don’t file for bankruptcy.? They play for time.

They hold an option with an uncertain expiry date.? When will we run out of cash?? Any way to conserve cash or sell off assets could lengthen the time to expiry, and maybe, just maybe, the economy will turn, or the pricing cycle will turn for the products, or enough other firms will fail, that the remaining liquidity lowers financing rates enough that the company can re-liquefy and survive.

The thing is, a company’s liquidity only becomes an issue when its ability to generate cash flow adequate to service creditors is questionable.? A company can say all it wants, “But we have valuable assets.? We’re not near insolvency!”? Fine.? Sell some of those valuable assets and generate liquidity.? “But it’s a bad market, we don’t want to hit low bids.”? This explains why the solvency as well as liquidity is questioned.? The assets aren’t worth as much as previously imagined.? Perhaps on a fair value basis, during the period of stress, net worth is negative.

Will the banks extend short term loans against unencumbered assets?? Can the firm do a private placement with some prize asset as security? No?? Perhaps the assets are worth considerably less than thought.? A healthy premium of the value of assets over liabilities will almost always be able to attract financing.? But when you are close to the line in a bad environment, any small premium will seem like an illusion to lenders.

So, in a large majority of cases, if there are liquidity problems, it is because there are solvency problems as well.? Here’s one more test: if a firm is suffering from low liquidity, but has valuable assets, why not sell out to another public firm, or go private, and let private equity solve the liquidity problem?? After all, they would like to buy valuable assets at a discount, right?? Right?!

🙁 Well, I would hope so, but during bad periods in the credit cycle, that doesn’t happen often.? So, the way I think is this: most hard liquidity problems are solvency problems, and vice-versa.? They are non-identical twins that don’t stray very far from each other.

Okay, that was theory, now for practice.? Credit sensitive financials have been getting whacked lately, and deservedly so.? Here are the examples:

My examples should confirm to you that insolvency and illiquidity are closely related.? In my investing, I like owning companies that are not playing it too close to the line.? In bad economic environments, the line moves, and companies that thought they could survive can’t.? A warning to all of us who invest, and to those who manage companies: play it safe.? Never take risks that could endanged the franchise, and don’t invest in companies that do so.

5 thoughts on “Nonidentical Twins: Solvency and Liquidity

  1. As an investor, I want companies to bet the farm if the expected returns are worth it and I understand what they are doing so I can limit my exposure. As an employee and sole proprietor, betting the farm is utter foolishness.

  2. As an investor, I never want my company to bet the farm. I want them to survive; that’s how you make money. Firms with lower amounts of debt tend to beat firms with higher amounts of debt in the long run.

    At least, that’s the way that I do it. Venture capital runs at higher leverage, and often they do well, but then they have control, and I’m just an outside passive minority shareholder.

  3. Mr. Merkel:

    Thank you for the great article. I just finished the first level of the CFA curriculum this June and this is consonant with what was written (briefly) in the corporate finance portion–albeit in the context of current market conditions.

  4. “…why not sell out to another public firm, or go private, and let private equity solve the liquidity problem?”

    I guess in some ways private equity coming in could be the same as creating a liquidity event so as to avoid insolvency, but that’s not common, at least it shouldn’t be (not in these markets). Going private isn’t a real solution to preventing insolvency in most cases. True buyout strategies are aimed at value opportunities that have potential to be turned around, not sub-par assets that lost all value with no definite potential for turning around. There are all kinds of philosophical discussions this could bring up, such as why the KKRs and Carlyles of the world would get into buying secondary debt, only to have to shut down entire funds when market dynamics they don’t really understand change. Still, overall I agree with the analysis … liquidity and solvency go hand in hand. Fundamentally and technically, this is true; unfortunately, it doesn’t always play out that way.

Comments are closed.

Theme: Overlay by Kaira