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Insolvency vs Illiquidity: The Similarities and Differences

Insolvency vs Illiquidity - The Similarities & Differences
Lauren Ward

Lauren Ward

Updated June 9, 2022
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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
Illiquidity and insolvency are both terms used to describe a business that is dealing with cash flow problems or operational inefficiencies. But they actually have different meanings. Illiquidity is when a company does not have enough current assets to meet its current liability obligations. Insolvency, on the other hand, is when a company does not have enough total assets to satisfy its total liabilities.As a small business owner, it’s important to understand the difference between insolvency and illiquidity, how insolvency can lead to illiquidity, and what you can do to remedy either problem, and get your business back on the road to financial health.

What Is Illiquidity?

To understand illiquidity, it helps to understand liquidity. When a company has liquidity, it means it has the ability to pay its current debt and liability obligations with its current assets. It does not need to liquidate any of its long-term assets to pay its short-term liabilities. Liquidity is a term often associated with a company’s cash flow and working capital management. Current liabilities may include:
  • Accounts payable
  • Bills/utility payments
  • Loan payments
  • Taxes
Current assets may include:
  • Accounts receivable
  • Cash
  • Inventory
  • Securities: stock, treasury bills, or any security that can easily be sold
The opposite of liquidity is illiquidity. When a company is illiquid, it does not have the ability to pay its current liabilities with its current assets. If not remedied, illiquidity can lead to more serious financial problems in the future, including insolvency.

How Does Illiquidity Work?

A business that is illiquid is generally facing short-term cash flow issues. Its future is not necessarily in question, but it could be. The good news is that a business owner can often solve any issues with illiquidity by providing more capital, getting a small business loan or line of credit, and/or restructuring the company’s operations. Recommended: Understanding Different Types of Small Business Loans 

What Is Insolvency?

To understand insolvency, it helps to understand solvency. When a company is solvent vs insolvent, it means that its assets are worth more than its liabilities and it can meet its long-term debt obligations without any trouble. If a business is unable to cover all of its debts (even if it liquidated all of its assets), it is considered insolvent. Financial solvency is essential for the long-term survival of any business.

How Does Insolvency Work?

When a business is insolvent, it means that the owners’ (or shareholders’) equity, which is the company’s assets minus its liabilities, is negative. While it’s not uncommon for new small businesses to have negative owners’ equity on the balance sheet, solvency typically improves as a company matures. However, businesses can also move in the wrong direction, going from solvent to insolvent. This can happen for many different reasons, including poor cash management, a reduction in cash inflow, an increase in expenses, lawsuits, and/or not adapting to changes in the marketplace.Insolvency can lead to bankruptcy. It can also lead to insolvency proceedings, in which legal action is taken against the insolvent business and its assets may be liquidated to pay off outstanding debts. Recommended: Guide to Insolvency vs Bankruptcy 

Insolvency vs Illiquidity Compared

Illiquidity and insolvency have similarities, but also some key differences. Here’s how they compare.  

Similarities

Both illiquidity and insolvency:
  • Are forms of financial distress
  • Occur when a company is unable to pay upon its debts because of a shortage of assets
  • Represent an immediate problem that must be addressed 
  • Can lead to bankruptcy (although insolvency is more serious)
  • Can be solved 

Differences

Here’s a look at how liquidity and insolvency differ:
  • Illiquidity is a short-term problem; insolvency is a long-term problem  
  • Illiquidity is when a company doesn’t have enough in liquid assets to cover its current debts; insolvency is when a company's overall debt exceeds its total assets.

Dealing With Liquidity Issues

If your business is in a state of illiquidity, you may be able to prevent insolvency by taking some of the following steps.
  • Sell off unproductive assets. Any asset that is not generating cash flow isn’t doing your business any good. Consider selling any idle machinery, unused computers, or rarely used vehicles.
  • Reduce overhead costs wherever possible. You may be able to improve cash flow by reducing how much you spend on marketing, subscriptions, and any other indirect expenses. 
  • Be aggressive with accounts receivable. Don’t let customers go months on end without paying their invoices. Call and/or send reminder emails to get them to pay sooner.
  • Look into a line of credit. A business line of credit might help you cover gaps in cash flow due to payment schedules. 
  • Consider refinancing your debt. This could lower your monthly bill. However, it may mean paying more in interest over the long run.
  • Consider invoice financing: Invoice financing can help solve short-term cash flow problems by providing immediate payment for your unpaid invoices (in exchange for a fee).

When Does Illiquid Become Insolvent?

If a company is unable to solve its cash flow issues (either by liquidating once illiquid assets, or raising capital internally or externally), that company could easily become insolvent.  If your business’s operating performance struggles for a prolonged period of time, and your short- and long-term cash inflows are no longer able to meet your financial obligations, the company could become insolvent. This means that its total debt has become larger than its total assets and you would not be able to cover your obligations even if you sold off all of your assets. 

Dealing With Insolvency

Moving a business from insolvency to solvency typically entails managing your debt and improving your cash flow. Here are some steps you can take.
  • Attack your debt. List all of your company’s debts in order of priority. Focus on debts that need to be paid immediately (such as those that could interrupt operations or lead to legal trouble if not paid on time) first. 
  • Follow up on unpaid invoices. Be sure to collect on any money that is due to your business.
  • Reach out to your creditors.  If you explain your current situation, they may be willing to restructure your debt to make your payments more affordable.
  • Find ways to decrease spending. Cut out all unnecessary costs and also look for cheaper suppliers for materials, stocks, and/or insurance. 
  • Boost your customer base. Try to increase sales by using customer feedback, increasing social media and email marketing, and learning from other businesses.

The Takeaway

Illiquidity is when a company lacks the appropriate amount of liquid assets to pay its current obligations and debts. It can happen for many reasons, and does not necessarily mean a business is in long-term trouble. Insolvency is when a company lacks the proper amount of assets (liquid or illiquid) to cover its debts and liabilities. In terms of financial distress, it is much worse to be insolvent than it is illiquid. You may be able to avoid illiquidity and insolvency by choosing the right loan product. Compare business loan rates at Lantern Credit today. There are many loan products on the market that may fit your business model better than a standard term loan — such as invoice financing, business lines of credit, or merchant cash advances. Illiquidity is when a company does not have enough current assets to meet its current liability obligations. Insolvency is when a company does not have enough total assets to satisfy its total liabilities.The goal of any business is to maintain both liquidity and solvency. This means you have enough cash flow to meet your current obligations and enough assets to remain operational in the long term. Having both liquidity and solvency will help your company overcome financial challenges, secure small business loans with favorable rates and terms, and continue to grow.

3 Small Business Loan Tips

  1. Generally, it can be easier for entrepreneurs starting out to qualify for a loan from an online lender than from a traditional lender. Lantern by SoFi’s single application makes it easy to find and compare small business loan offers from multiple lenders.
  2. If you are launching a new business or your business is young, lenders will consider your personal credit score. Eventually, though, you’ll want to establish your business credit.
  3. SBA loans are guaranteed by the U.S. Small Business Administration and typically offer favorable terms. They can also have more complicated applications and requirements than non-SBA business loans.
Photo credit: iStock/ferlistockphotoThe tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.LCSB0322015

Frequently Asked Questions

Is liquidation the same as insolvency?
Can a company be solvent but illiquid?
What are liquid and illiquid assets?

About the Author

Lauren Ward

Lauren Ward

Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
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