Illiquidity, Solvency & Insolvency : A Link to Bankruptcy Procedures

 

 Snehasish CHINARA In this article, Snehasish CHINARA (ESSEC Business School, Grande Ecole Program – Master in Management, 2022-2025) delves into the illiquidity, solvency and insolvency, key concepts in that connect financial distress and bankruptcy procedures.

Illiquidity

Illiquidity refers to the inability of a company or individual to convert assets into cash quickly enough to meet short-term financial obligations as they come due. This condition arises from a mismatch in the timing of cash inflows and outflows rather than a fundamental deficiency in overall financial health. For instance, a firm might hold substantial non-liquid assets (e.g., accounts receivable or inventory) that are valuable but not immediately accessible for use in settling debts. Illiquidity is generally viewed as a short-term liquidity risk and is often addressed through measures such as enhanced cash flow management, securing bridge financing, or leveraging credit facilities.

Solvency and Insolvency

Solvency refers to the financial health of an entity, where its assets exceed its liabilities, and it can meet its financial obligations as they fall due (although not in the short term as explained below). A solvent entity demonstrates financial stability and sustainability, which are key factors for stakeholders, such as debt holders (for liquidity reasons at the time debt deadlines) and especially equity holders (for performance reason).

Conversely, insolvency is a financial condition in which an entity’s liabilities exceed its assets, or it is unable to meet its debt obligations as they become due. It represents a state of long-term financial distress, indicating that the entity lacks sufficient resources to satisfy its obligations, even with adequate time to manage cash flows.

Insolvency can manifest in two primary forms:

  • Balance Sheet Insolvency: Occurs when the total liabilities of a company exceed its total assets. This is typically assessed using the entity’s balance sheet, where negative equity (assets minus liabilities) signals insolvency.

  • Cash Flow Insolvency: Occurs when an entity cannot pay its debts as they fall due, despite potentially having assets that exceed liabilities. This happens when illiquid assets cannot be quickly converted to cash to meet immediate obligations.

Insolvency is distinct from illiquidity in that it reflects a fundamental imbalance in financial health rather than a short-term cash flow issue. Prolonged insolvency often leads to bankruptcy filings, where legal proceedings determine whether the business should be restructured or liquidated.

Valuation Perspective: Solvency and Insolvency via Net Present Value (NPV)

Formula for Net Present Value (NPV)

The Net Present Value (NPV) is calculated using the following formula:

Figure 1. Net Present Value (NPV) Formula

In this context, cash flows represent the value generated by the firm’s assets, while the discount rate reflects the required return on debt and equity financing. A positive NPV signifies that the firm or project creates value above its cost of capital, while a negative NPV indicates value destruction and financial risk.

From a valuation standpoint, Net Present Value (NPV) is a crucial metric that aligns with the solvency status of an entity. NPV evaluates the difference between the present value of cash inflows and the present value of cash outflows over a given period. It serves as an indicator of the financial viability of a firm or project.

Solvent Firms: NPV > 0

  • A positive NPV indicates that the firm or project is generating value in excess of the required rate of return.

  • Such firms are financially sustainable, with the potential to attract investments, repay debts, and grow operations.

  • Example: A profitable company with strong operational cash flows and prudent capital investments will exhibit a positive NPV.

Insolvent Firms: NPV < 0

  • A negative NPV signals that the firm or project is destroying value, as cash outflows exceed the discounted cash inflows.

  • These firms struggle to generate sufficient returns, often resulting in financial distress and eventual insolvency.

  • Example: A company burdened by declining revenues, rising costs, and high-interest obligations may show a negative NPV.

Bankruptcy Basics

Bankruptcy is a legal framework that helps individuals and businesses unable to meet their financial obligations in the short term. When a company files for bankruptcy, it either seeks to reorganize its debts and operations or liquidate its assets to repay creditors, depending on the type of bankruptcy pursued (Chapter 7 for liquidation or Chapter 11 for reorganization procedures in US bankruptcy law). Reorganisation can offer a pathway to stability, enabling companies to mitigate debt burdens, restructure, and potentially preserve jobs. In this post I explain the link between the two academic concepts of illiquidity and insolvency and the two paths of bankruptcy of liquidation and reorganization.

Liquidation (Chapter 7 Bankruptcy)

Liquidation, often governed by specific bankruptcy codes such as Chapter 7 in the U.S., involves the complete dissolution of a financially distressed entity. Under this process, the firm’s assets are sold off to repay creditors in a legally prioritized manner. Liquidation is typically the final recourse for insolvent entities that lack the ability to restructure or continue operations. It marks the end of the entity’s existence, with any remaining proceeds distributed to stakeholders after settling liabilities.

Figure 2. Number of Chapter 7 Bankruptcy Filings (2013-2022)

Source: computation by the author (data: US Courts Statistics).

Reorganization (Chapter 11 Bankruptcy)

Reorganization, outlined under codes such as Chapter 11 in the U.S., is designed for insolvent entities seeking to restructure their debts and operations while continuing business activities. This process allows the firm to negotiate with creditors to modify repayment terms, reduce debt burdens, or inject fresh capital. Reorganization aims to restore financial stability, preserving the firm’s value and jobs while maximizing recoveries for creditors. It is a more sustainable alternative to liquidation for viable but financially distressed firms.

Figure 3. Number of Chapter 11 Bankruptcy Filings (2013-2022)

Source: computation by the author (data: US Courts Statistics).

Link between Illiquidity, Solvency, and Bankruptcy Outcomes

The determination of whether an illiquid firm should undergo liquidation or reorganization is heavily influenced by its solvency or insolvency status. These financial characteristics provide a structured framework to allocate resources and protect stakeholder interests, ensuring an efficient resolution process that minimizes economic disruption.

Illiquidity and Insolvent Companies: Liquidation

A firm that is both illiquid (unable to meet its short-term obligations) and insolvent (its liabilities exceed its assets) is in a critical financial position. These firms lack the operational capacity to generate sufficient cash flows and the balance sheet strength to cover their obligations. By selling off assets, the firm can repay creditors in an orderly and legally prioritized manner, thereby closing its operations permanently. Liquidation minimizes further losses and provides a clear exit for stakeholders, ensuring that remaining value is distributed equitably.

From a financial perspective:

  • Asset Realization: Liquidation involves selling the firm’s assets, converting illiquid assets (e.g., inventory, real estate) into cash to settle liabilities.

  • Creditor Recovery: Creditors are repaid in a hierarchical order—secured creditors (e.g., bondholders) take precedence, followed by unsecured creditors and equity holders.

  • Economic Efficiency: Liquidation prevents further erosion of value by discontinuing loss-making operations. The proceeds can be redeployed to more productive uses within the economy.

Example: In high-leverage industries such as retail, where asset values may plummet during financial distress, liquidation can be a pragmatic approach to salvaging any remaining value for stakeholders.

Illiquidity and Solvent Companies: Reorganization

Firms that are illiquid (unable to meet its short-term obligations) but remain solvent (its assets exceed its liabilities) present a different scenario. These companies face temporary liquidity constraints but possess the potential for recovery, given their fundamentally sound financial or economic position. By restructuring debts and operations under judicial supervision, reorganization allows the firm to stabilize its finances, regain liquidity, and continue its business activities. This approach helps preserve jobs, maintain operational continuity, and often results in better recovery for creditors compared to liquidation.

Key financial points include:

  • Debt Restructuring: The firm negotiates with creditors to extend repayment timelines, reduce interest rates, or convert debt into equity, improving short-term liquidity.

  • Operational Optimization: Reorganization often involves strategic cost-cutting, asset divestitures, or operational restructuring to enhance cash flow generation.

  • Stakeholder Value Preservation: By avoiding liquidation, reorganization preserves enterprise value, ensuring better recovery for creditors and protecting equity holders’ stakes.

  • Long-term Viability: Reorganized firms can often leverage their existing assets and market position to regain profitability, benefiting employees, suppliers, and customers.

Example: Airlines facing temporary cash flow issues during economic downturns often turn to reorganization. By negotiating with lessors, restructuring debt, and optimizing operations, they can avoid liquidation and return to profitability.

An Efficient Bankruptcy Procedure

An efficient bankruptcy procedure should distinguish between these two cases (solvent and insolvent firms), leading illiquid and insolvent firms into liquidation and illiquid but solvent firms into reorganization. This tailored approach ensures that:

  • Insolvent firms with no viable future are dissolved efficiently, maximizing recoveries for creditors.

  • Solvent but illiquid firms are given a second chance to reorganize and emerge stronger, preserving value for all stakeholders.

Figure 4. Efficient Bankruptcy Procedure

Such a system not only protects creditors and investors but also fosters economic stability by maintaining productive assets and employment where possible, while swiftly resolving entities that no longer contribute to the economy.

This approach not only maximizes financial efficiency but also aligns with broader economic objectives:

  • Maximizing Creditor Recovery: Insolvent firms should be liquidated to repay creditors as much as possible, avoiding the dilution of recovery through prolonged unviable operations.

  • Optimizing Economic Resources: Solvent but illiquid firms should undergo reorganization, preserving their workforce, intellectual property, and market position, which might otherwise be lost in liquidation.

  • Minimizing Systemic Risk: A clear distinction between liquidation and reorganization reduces uncertainty in financial markets, particularly for industries prone to cyclical liquidity crises.

Why Should I Be Interested in This Post?

This post serves as a comprehensive guide to understanding the critical financial concepts of illiquidity, solvency, and insolvency, while connecting them to practical applications in bankruptcy procedures. Whether you’re a finance student, a professional exploring corporate restructuring, or simply curious about the mechanisms behind bankruptcy codes, this article bridges theoretical knowledge with real-world implications.

By explaining the nuanced relationship between illiquidity and solvency/insolvency, and their impact on choosing between liquidation and reorganization, it offers insights into how firms navigate financial distress. Furthermore, it highlights how an ideal bankruptcy procedure aligns with maximizing economic value and minimizing systemic risks.

Related posts on the SimTrade blog

   ▶ Snehasish CHINARA Chapter 7 vs Chapter 11 Bankruptcies: Insights on the Distinction between Liquidations & Reorganisations

   ▶ Snehasish CHINARA Chapter 7 Bankruptcies: A Strategic Insight on Liquidations

   ▶ Snehasish CHINARA Chapter 11 Bankruptcies: A Strategic Insight on Reorganisations

   ▶ Akshit GUPTA The bankruptcy of Lehman Brothers (2008)

   ▶ Akshit GUPTA The bankruptcy of the Barings Bank (1996)

   ▶ Anant JAIN Understanding Debt Ratio & Its Impact On Company Valuation

Useful resources

US Courts Data – Bankruptcy

S&P Global – Bankruptcy Stats

Statista – Bankruptcy data

About the author

The article was written in January 2025 by Snehasish CHINARA (ESSEC Business School, Grande Ecole Program – Master in Management, 2022-2025).