Why Do Businesses Go Bankrupt? A Crisis of Liquidity
Many businesses declare bankruptcy every day. The American Bankruptcy Institute says on average about 26,000 businesses went bankrupt each year from 2013 to 2017. This statistic doesn't include the number of small businesses that just close their doors and walk away from their failing businesses.
There are some typical reasons why businesses close, but in most cases, they boil down to neglecting the basic business principles of liquidity, solvency, and viability. Here is a brief discussion of each term and how it is important in keeping a business from closing or declaring bankruptcy.
Liquidity of a Business
Liquidity is the most short-term of these measures because it refers to the ability of a business to quickly turn assets into cash without loss. The principle works like this: Let's say you need cash to pay bills. The easiest way to get it is to sell an asset. If you sell cash or use it to pay bills, it's worth 100 percent of its value. But if you try to sell any other asset, it won't be worth 100 percent.
So you look around and think, "Well, I can collect on some receivables." But you can't collect enough, or you end up selling the receivables to a factor at a big discount. so you try to return some unopened boxes of supplies to the office supply place. Or you return some unused products to your supplier. You know if you tried to sell equipment, you would take a loss, because it has depreciated.
If you are liquid, you have enough assets in cash to be able to pay your immediate bills or pay your employees. Most businesses don't have a lot of extra cash sitting around, but they should be able to know that they have enough, from revenue or selling stuff, to pay bills as they come due. This is called a positive cash flow, and it means liquidity.
Solvency of a Business
The principle of solvency is related to liquidity, but it is a little broader. If a business is solvent it has enough assets to cover its liabilities. If all of the creditors of the business called in their loans and demanded payment (kind of like a 'run on the bank' for a business), the business would have to sell or dispose of current assets, at a loss.
Solvency is measured with a business ratio called the "current ratio," which compares current assets (receivables, supplies, and inventory) to current liabilities (those debts you owe that are due within the next year, like your taxes, payroll taxes, and monthly payments on your business loan). The "current ratio" is supposed to be 2:1. That is, the value of your current assets should be twice the amount of your current liabilities.
As I mentioned above, it is difficult to sell off assets quickly without taking some loss, so you need more assets to cover your liabilities. Solvency, then, is the ability of a business to maintain a current ratio of 2:1, so it can handle emergencies and pay its bills over the short term (under a year).
Viability of a Business
The concept of viability is often discussed with living beings (newborn babies, for example) and their ability not only to survive but to thrive. Economic viability means continuing sustainable profits for a business over a period of time. It doesn't mean that every quarter is profitable, but that over time the business is profitable, which provides for both liquidity for emergencies and solvency for current needs.
Remember that a business can be profitable and still not have enough cash. Profits are just on paper; cash is in the bank.
Back to my original point: businesses often go bankrupt because they forget about the basics:
- The business must have enough cash to cover emergencies (liquidity);
- The business must have enough assets so that if loans must be paid off, or taxes must be paid, the business can cover these "calls" on its assets (solvency); and
- The business must continue to be profitable, which means that it continues to bring in more income than revenue, thus building up cash and other assets (viability).
Basic business principles. Forget them at your peril.