Solvency & Liquidity – What does this mean?

Friday, September 30th, 2011

I’ve recently had occasion to answer these questions for clients, though for very different reasons.

In the first instance, the client’s business is in serious distress.   It’s a vicious circle – on the one hand, turnover has declined, but on the other hand, there are no funds to fund materials and labour for turnover if it was to suddenly turn around! The business is insolvent and I’ve had to advise the client to make the hard decision to close the doors. It’s a difficult decision to make, because no one likes to admit that they may have failed. However, it’s better to make this kind of decision early and then have time (and credibility) to start again, than delay what is the inevitable. It will only get, and be worse, if he waits!

In the second instance, the client is not insolvent at all, but very illiquid, – and simply because he has been unable to recover certain significant debts due to him, on time. As a result, one of his suppliers – who hasn’t been paid as a result – has been going around telling everyone the client is going out of business, and that he is going to ‘liquidate’ him. (in the business sense, hopefully!). In this instance, the supplier is being very naughty (slander actually) and just making things unnecessarily difficult in an already difficult situation. Business people need to work together and not against each other, as doing business is tough enough these days.

Business owners really do need to know what these terms mean, and what the implications are for them, so I thought it would be helpful to provide some short explanations.

A solvent business is one in which the value of its assets exceeds its liabilities. Even simpler – what one owns, amounts to a greater value than what one owes.

A liquid business is one which is able to pay its debts in the ordinary course of business and continue to do so within the next year.

A business that has liquidity problems is not necessarily insolvent. In fact, such a business could be significantly solvent – its asset value significantly exceeds its liabilities. Liquidity is all about cash, and how it’s managed.

The Companies Act in South Africa is particularly tough on directors that don’t take due care with the solvency of their businesses. I suspect that the courts will be just as tough on members of close coprporations and sole proprietors, if they trade recklessly. (in insolvent circumstances).  In managing this important aspect, liquidity has to be taken into account.

When deciding on liquidity, directors should at least consider the following:
• Is the company making its sales targets; have contracts been cancelled etc?
• Is the company able to collect its receivables timeously?
• Is it running into difficulty paying salaries and its commitments to SARS for tax and VAT?
• Are payments to critical suppliers being deferred?
• Are the company’s working capital facilities adequate, or are they already ‘maxed out’?
• Are there any impending legislative or industry changes which could seriously impact on company performance in the short term?
• Can the company continue to service its long term commitments?
• Are there any other cash resources available at short notice?

Directors/members/sole proprietors should be able to answer “yes” to these questions before further committing their businesses financially.
And if they can’t answer “yes” to at least a majority of those questions, they too may have to make the hard decisions!