Illiquidity and Insolvency for Debtors

Any entity that has debt can become illiquid or insolvent. Illiquid means that the debtor cannot service the debt at the time with liquid assets (which in accounting class generally means cash, accounts receivable and inventory – in decreasing order of liquidity), not because it does not have assets that can cover the debt or the cash flow – but rather it is not able to convert its assets into cash immediately. This liquidity crisis is also known as “cash flow insolvency”

Insolvency means that the debtor cannot cover its debts. This usually leads to bankruptcy and restructuring.

A liquidity problem can turn into an insolvency problem.

Why Liquidity Analysis is Important

Illiquidity is problematic because if assets need to be liquidated immediately to service debt, this creates a disproportionate advantage for any potential buyer.

Buyers need to complete due diligence on assets and will need time to secure financing – whether through raising debt or equity. If selling needs are immediate, there is a limited buyer universe which leads to very limited competitive pricing tension. Cash is king is an apt phrase here – someone with deep pockets when everyone is in distress, like Warren Buffett during the financial crisis, is able to snap up valuable assets at a steep distressed discount.

The creditors who are the most conservative on liquidity analysis are commercial banks. They are in the business of lending money and getting a return – not losing money. Banks are accordingly usually the most senior in the capital structure (they have priority of claims above just about any other stakeholder).

This actually works better for any debtor, because banks become much more aggressive in reclaiming their money when they are not the most senior. If other creditors are equal in priority (pari passu) with the banks, the banks will generally try to force the debtor’s hand. Banks are investing other people’s money and cannot afford, nor are they allowed by regulators, to make riskier lending decisions like a bondholder would.

Liquidity Ratios and Translation to Security/Collateral

In accounting class, the major liquidity ratios are the current ratio, the quick ratio and the cash ratio.

The current ratio is current assets over current liabilities. How well do current assets (cash, marketable securities, accounts receivable and inventory) cover upcoming payments?

The problem with this ratio is that inventory generally takes time to clear and if forced to liquidate may receive a steep discount to their market price. If inventory is comprised of raw materials that are fungible commodities, they may be worth their book value. If they are more bespoke without obvious clearance buyers, they may get a material discount.

The next ratio is the quick ratio. This is cash, marketable securities and receivables. Receivables are generally easy to factor – they are claims that will receive in upcoming payment. Generally speaking, a financial institution should be able to buy the receivables at an appropriate discount rate to the claim owed at maturity. However, this will vary depending ont he creditworthiness of the receivable as well. A receivable from IBM will trade much closer to its par value than a receivable from a junior mining company with its own liquidity problems.

The last ratio is the cash ratio – and by far the most conserative. Cash is generally not given a haircut. Cash can be immediately used to service debt (unless it is restricted cash set aside for something else or has some other limitation).

Asset Based Lending (ABL) and Borrowing Base Facilities

How do banks and alternative lenders look at these ratios? In asset based lending (ABL), generally there will be a borrowing base which takes current assets and haircuts them in order to provide a margin of safety for the lender.

The banks or alternative lenders have first lien on the current assets pledged and there will be a cap on how much the borrower can have outstanding as a percentage of the borrowing base. The loan is usually a revolving loan (an ABL revolver).

For example it could be a 50% haircut on inventory, 80% haircut on receivables and 0% haircut on cash.

So with Cash of $100 million, receivables of $100 million and inventory of $100 million, this means a borrowing base of $230 million.

This works for both the banks and for the borrower. For the banks, because of the ample collateral assigned to the loan, they are relatively more assured that depositor money is safe and accordingly the capital charge on their own regulatory ratios – Common Equity, Common Equity Tier 1 (CET1), and so on – is much lower. As such, they do not have to put up as much capital against the loan and their return metrics are much higher – as measured by return on risk weighted assets and economic return.

For the borrower, this translates into a far lower interest rate than an unsecured loan.

There are many structures that banks can provide for borrowers, including revolvers funded by securitizing receivables.