Corporate Finance For Dummies
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If your company is owed money but doesn't have enough to pay the bills in the meantime, you’re a victim of liquidity risk! The most extreme form of liquidity risk, called insolvency, occurs when a company is completely incapable of paying the money it owes and must file some form of bankruptcy, sell its operating assets to make the payments it owes, or simply go out of business.

Insolvency doesn’t necessarily happen when a company is doing poorly; quite the contrary, it can happen just as easily when a company is too successful.

Imagine for a moment that you own a company that sells large manufacturing robots. Each one sells for $1 million. Now, $1 million isn’t a cheap price for a piece of equipment, even for very large companies, so odds are your customers will pay for these robots on credit, making monthly payments over the course of several months or years.

Say this company of yours becomes wildly popular and starts making lots of sales with very high profits. The problem comes in when your company starts spending more money to make the machines you’re selling than it’s receiving in monthly payments.

In order to fulfill these sales orders and make the big profits you want, you still have to order supplies to build the machines you’re selling. If you spend all your money on supplies but don’t receive enough in monthly payments from past customers to cover the cost, then you’re putting your company at liquidity risk.

This scenario isn’t insolvency yet because you’re still making payments, but liquidity risk can turn into insolvency if the problem isn’t resolved quickly.

That’s not to say that liquidity risk can’t be derived from simple poor financial management, though, either. If a company derives too much of its capital from debt, it may find itself in a position where it can no longer afford to make the interest payments and should probably consider raising equity to decrease the interest payments.

A lack of customers stemming from an inability to compete or generalized market risk can also cause insolvency.

When the banks involved in the 2007 financial collapse stopped generating revenues as a result of their poor management of credit risk, they became incapable of making payments on those loans they had taken themselves, including the interest owed on deposits and other bank products.

This scenario led many of even the largest banks to become insolvent as a result of liquidity risk. Many banks went out of business, and some of the largest banks in the world required government assistance.

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Kenneth W. Boyd has 30 years of experience in accounting and financial services. He is a four-time Dummies book author, a blogger, and a video host on accounting and finance topics.

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