You’re representing a client in a fraudulent transfer case, and opposing counsel starts throwing around terms like “insolvent” and “liquidity crisis.” Are they talking about the same thing? Should you be worried about both?
Solvency and liquidity may sound like accounting jargon that means roughly the same thing, but confusing them in litigation can lead to costly consequences, so I wanted to break it down simply:
Solvency addresses the big picture question: Can this company survive long-term? Do its assets actually outweigh its debts? Think of it as asking whether someone could theoretically pay off everything they owe if they had to liquidate, or the ability to pay both current and non-current liabilities.
Liquidity is more immediate: Can this company pay its bills right now? It is the ability to meet just the current liabilities of the company. You might own a million-dollar building, but if you can’t make payroll next week, you have a liquidity problem.
Consider solvency as the ability to fulfill long-term financial obligations, while liquidity looks at short-term commitments. I’ve worked on cases where a company looked solid on paper but couldn’t scrape together enough cash to keep operating. That distinction matters enormously in court.
The Solvency Opinion
Judges want more than assertions when financial health becomes central to litigation, whether in bankruptcy disputes, fraudulent conveyance claims, or contested transactions. They want a solvency opinion from a qualified expert.
A proper solvency analysis requires three separate tests. A company must pass all three to be deemed solvent.
Test #1: Balance Sheet Examination
Are the company’s assets really worth more than what it owes?
This gets complicated quickly. We’re not relying on book values from years-old accounting records. We need to determine what everything would actually sell for today. That machinery carried at $500K on the books might fetch $100K at auction. Meanwhile, real estate purchased in 2019 might be worth double the original cost.
Test #2: Cash Flow Analysis
Can this company reasonably expect to pay its debts as they come due? This requires developing and stress-testing financial projections under multiple scenarios.
We typically run three cases: management’s base projection, a realistic middle scenario, and a downside case. We examine debt-to-equity ratios, interest coverage, and whether cash flow can support the debt load. This test bridges solvency and liquidity by focusing on theoretical value, timing, and the reality of the cash flows.
Test #3: Capital Adequacy Assessment
The Capital Adequacy Assessment asks: Does this company have sufficient financial resources to weather normal business fluctuations?
This goes beyond meeting current obligations. We evaluate whether the company has enough capital to continue operations, make necessary investments, and handle typical business challenges. The analysis covers liquidity reserves, business volatility, access to additional financing, and reasonable operating buffers.
Liquidity Analysis
While solvency questions often dominate litigation, liquidity analysis frequently reveals a compelling story, particularly in preference claims or operational mismanagement cases.
Key liquidity metrics include:
- Current Ratio: The fundamental measure of whether short-term assets can cover short-term debts.
- Quick Ratio: A more conservative calculation that excludes inventory and other less liquid current assets.
- Cash Flow Analysis: Much like in the solvency opinion – What’s coming in versus what’s going out for payroll, vendors, rent, and debt payments?
- Working Capital Trends: Sometimes the trajectory matters more than absolute numbers. Is liquidity improving or deteriorating?
- Operating Cycle Analysis: How quickly can this company convert inventory to cash and collect receivables?
Liquidity analysis becomes essential when plaintiffs argue that a company’s inability to pay creditors constitutes constructive fraud or breach of fiduciary duty. The focus shifts from total asset value to timing and cash management capabilities.
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Whether you’re defending a transaction, planning a restructuring, or building a litigation strategy, accurate financial analysis from the outset prevents costly surprises later.
At MSG Accountants, Consultants, and Business Valuators, we specialize in solvency and liquidity analysis that stands up in court. We understand what evidence judges find persuasive and how to present complex financial concepts.
For more information, contact our office at msgcpa@msgcpa.com or call 646-661-3800.