When making investment decisions in a company, investors consider various factors. Among these, profits are the most crucial as they can impact the investors’ future returns. However, a company’s earnings may not be meaningful if it has cash flow problems or operational inefficiencies. There are two terms, closely related to each other, which describe these problems, illiquidity, and insolvency.
Some investors may confuse these two due to their similar nature. However, it is crucial to differentiate between them for better decisions. The term illiquidity is the opposite of liquidity, while insolvency is the antonym of solvency.
What is Illiquidity?
Before understanding what illiquidity is, it is crucial to define liquidity. Liquidity is a company’s ability to meet its current liability obligations from the current assets it has. A company’s liquidity shows whether it has sufficient resources to repay all its current liabilities without using its long-term assets. Liquidity is a term often associated with a company’s cash flow and working capital management.
Illiquidity is the opposite of liquidity. When a company does not have enough current assets to meet its current liabilities, it is considered illiquid. Illiquid companies can face financial problems in the future. Usually, these companies have to reside in obtaining finance to meet their operations or generating assets internally. Investors don’t prefer investing in companies that have liquidity issues.
For investors, an investment’s liquidity shows how easily they can convert it into cash. Therefore, investors can easily obtain cash for a highly liquid investment as compared to an illiquid one. Usually, if an investment has an active market, investors will find it easier to convert it into cash. These may include stocks, which they can trade on stock markets. Similarly, they may consist of readily convertible government bonds.
Investors can calculate a company’s liquidity ratios to determine whether an investment is illiquid. These include ratios such as current, cash, quick ratios. Although illiquid investments are problematic, these issues usually resolve in a short while.
What is Insolvency?
Insolvency is the opposite of solvency. Solvency shows a company’s ability to run its operations in the long run. A company’s financial position plays a crucial role in its long-term operations. Therefore, solvency defines a company’s long-term financial position. It considers a company’s total assets and liabilities compared to current assets and liabilities for liquidity.
Insolvency represents a state of financial distress for companies in meeting their obligations. It can have a long-lasting effect on a company’s operations. Insolvency can also cause an eventual liquidation or legal actions against the company. There are several factors that can contribute to a company’s insolvency. Unlike illiquidity, the factors that cause insolvency come from long-term decisions.
Similarly, there are different types of insolvencies that companies may face. These may include cash flow or balance sheet insolvencies. For investors, insolvent companies can create many problems. However, companies that face insolvency can also recover. Like illiquid investments, investors also steer clear of investing in insolvent companies.
Investors usually use ratios such as the debt-to-equity ratio, debt-to-asset ratio, interest coverage ratio, etc., to determine if a company is insolvent.
Conclusion
Investors consider various aspects of an investment when making a decision. Among these, two crucial aspects are illiquidity and insolvency. Illiquidity is when a company does not have enough current assets to meet its current liability obligations. On the other hand, insolvency is when a company does not have enough total assets to satisfy its total liabilities.
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