“How did you go bankrupt?’ Two ways. Gradually then suddenly.” – This quote often attributed to Mike Campbell in Ernest Hemingway’s 1926 novel, The Sun Also Rises highlights the often gradual process of financial decline leading to the sudden realization of a company’s insolvency and liquidation.

Redhouse Group, a prominent PR firm, has been declared insolvent. Following this, Nairobi burger chain Mama Rocks cofounder, Cytonn High Yield Solutions (CHYS), and Cytonn Real Estate Project Notes (CPN) have been placed under liquidation. Additionally, Invesco Assurance Company Limited was placed under liquidation by the Insurance Regulatory Authority (IRA) after facing insolvency petitions from claimants.

This raises the question; what is insolvency and how does it differ from liquidation?

Definition

Conventional thinking often sees insolvency and liquidation as closely linked, with one inevitably leading to the other.  Insolvency is a necessary precursor to liquidation; a company cannot be liquidated unless it is first insolvent.

However, the relationship is not always so straightforward. While insolvency creates the potential for liquidation, it doesn’t guarantee it.

Insolvency is the state where a company can’t meet its financial obligations as they become due, either because it doesn’t have enough assets to cover its debts or because it can’t generate enough cash flow to pay its bills. It’s like being unable to pay your rent or mortgage.

Liquidation, on the other hand, is the process of selling a company’s assets to pay off its debts. Think of it as the final act, the consequence of being insolvent. While they are related, they are not the same.

Insolvency is the condition and liquidation is the action.

Take for example a retail company that has been struggling for a while. They are not making enough sales, and their debts are piling up. They are unable to pay their suppliers and are constantly late on rent. This is insolvency. The company is in a financial bind, unable to meet its financial obligations.

If the situation worsens and the company can’t find a way to restructure its debts or find new investors, it might be forced into liquidation.

In liquidation, all the assets of the retail company, like its inventory, store equipment, and any remaining cash, are sold off. The money from these sales is then used to pay off the company’s creditors, such as suppliers, landlords and lenders.

Signs of Distress

The initial signs of distress often begin subtly, like a crack in a dam. Take Mike from the Finance Department in the retail company; he’s poring over the income statement, only to realize the business isn’t profitable. He then checks the balance sheet, and the liabilities outweigh the assets, confirming insolvency.

 However, these financial red flags aren’t always the first indicators.

A company in the automotive industry might be thriving, with a positive closing balance in the cash flow statement, impressive sales figures, and ample liquidity. But then, boom – the lead salesman unexpectedly leaves, taking crucial client relationships with them, or floods ravage the warehouse and offices, wiping out inventory and disrupting operations.

These unforeseen triggers, be it the loss of key personnel or a natural disaster, sow the seeds of distress, rapidly transforming a healthy business into one facing an uphill battle for survival.

Desperate Measures

When the seeds of distress take root, desperate measures become the norm. After Mike’s grim discovery, he approaches the CFO, who immediately calls for a crisis meeting. The first step is often a frank assessment of the situation, followed by a discussion of ethical compromises to avoid liquidation.

This could involve difficult choices, such as delaying payments to suppliers or even temporary layoffs.

The next step involves restructuring, which often leads to job cuts, salary reductions, and the painful shedding of non-essential assets. Simultaneously, the company aggressively seeks new investors or lenders, hoping to inject much-needed capital.

For instance, a struggling tech startup, facing declining cash reserves, might cut its marketing budget, freeze hiring, and aggressively pursue a bridge loan to stay afloat while seeking a strategic acquisition to survive.

The Fall

When all efforts fail, the inevitable fall into liquidation or insolvency becomes a stark reality. The formal process begins with a declaration of insolvency, often followed by the appointment of an official receiver or liquidator.

This insolvency practitioner takes control of the company’s assets, assesses its debts, and determines the best course of action.

The duty of the Official Receiver is to protect the interests of creditors while ensuring a fair and transparent process. Assets are then sold, and the proceeds are distributed among creditors according to a strict hierarchy.

The practitioners try to balance the interests of both debtors and creditors by exploring all possible avenues, including restructuring or a sale of the business as a going concern, before resorting to liquidation.

However, if the debts far outweigh the assets, liquidation is the only option. The company ceases to exist, and creditors may only receive a fraction of what they are owed. In such cases, the official receiver investigates the company’s conduct to identify any wrongdoing or mismanagement that may have contributed to the downfall.

Aftermath

“This would be a much better world if more married couples were as deeply in love as they are in debt,” Earl Wilson once quipped, a sentiment that resonates deeply in the aftermath of liquidation.

In Mike’s company, after the declaration of insolvency, the official receiver steps in to manage the distribution of assets. The process begins with secured creditors, those with specific claims against assets like property or equipment. Then come preferred creditors, such as employees’ owed wages and the government for unpaid taxes. Finally, unsecured creditors, including suppliers and bondholders, receive what remains.

In a surprising twist, the unexpected beneficiaries might include the legal and accounting firms that handled the liquidation, as their fees are often paid before unsecured creditors.

The consequences differ significantly between public and private companies for shareholders. In public companies, shareholders typically receive nothing, as their equity is wiped out. In private companies, the shareholders might be personally liable for debts, depending on the legal structure.

The lessons are harsh but clear: sound financial management, diversification of risk, and a culture of ethical decision-making are essential. Remember, a healthy company is built on trust and sustainable practices and never ignoring the warning signs.