Insolvency and illiquidity are two closely related terms. They refer to the financial state or condition of individuals, companies, corporations, or businesses.
As widely used among the financial industry, insolvency and illiquidity are defined as follows:
- Insolvency: the financial state where a debtor (a person or a business) cannot pay off its debts, liabilities, and other financial obligations as it becomes due, or after its due date, because of financial distress
- Illiquidity: the financial state where a business’s current assets or sufficient resources cannot satisfy its current liabilities, without having to resort to the disposal of its long-term assets or non-current assets (e.g., fixed assets, long term investments)
Insolvency vs. Illiquidity: the basics
While insolvency is based on a business’s total assets, illiquidity is based on a business’s current assets.
And while insolvency deals with a business’s total debts and liabilities (about to become due or are already due), illiquidity deals with a business’s current liabilities and other obligations.
Another distinction is that insolvency deals with long-term cash flow issues; illiquidity deals with short-term cash flow issues.
Lastly, insolvency and illiquidity may also be differentiated by looking at the options available to a business when one of these financial states happens.
Certain remedies for insolvency are outlined in the Bankruptcy and Insolvency Act (BIA) and the Companies' Creditors Arrangement Act (CCAA), such as submission of proposals or plans to creditors and/or restructuring the debts owed to these creditors.
While there is no federal law governing it, financial methods are available for illiquid businesses. These solutions are based on increasing their net income and cash flow.
Insolvency vs. Illiquidity under Canadian law
We can also look at the difference between insolvency and illiquidity from the perspective of Canadian law. These two financial states are covered by different Canadian federal laws and regulations. Also, different government authorities regulate insolvency and illiquidity.
Insolvency
Insolvent businesses, including those that are bankrupt, are defined by the BIA and the CCAA. These laws are administered by the Office of the Superintendent of Bankruptcy, which is the main government authority working with insolvent businesses or those at the brink of bankruptcy.
Under the BIA, insolvency happens (Section 2, BIA) when a Canadian business that’s not yet bankrupt whose total debts, obligations, and liabilities to creditors are over C$1,000 falls under any of the following circumstances:
- when it cannot meet its debts, obligations, and liabilities as they become due;
- when it stopped paying its current debts, obligations, and liabilities after they become due; or
- when its aggregate property is insufficient to pay all its debts, obligations, and liabilities – both those which are already due and will become due – even if sold out of a legal process.
Illiquidity
Canadian laws on liquidity are based on the fiduciary and financial regulation of various government or federal authorities such as the Office of the Superintendent of Financial Institutions (OSFI) as empowered by the Office of the Superintendent of Financial Institutions Act (OSFI Act) and the Bank of Canada through the Bank of Canada Act.
With the authority granted by these Acts, the OSFI and the Bank of Canada are among the regulators of the financial stability of certain corporations and financial institutions.
The OSFI and its regulations apply to financial institutions, businesses, companies, and corporations.
Know about the different laws on Canada’s financial regulation, the institutions that it governs, and how it affects these institutions
Do you have questions regarding financial regulation? Leave a comment below or consult with one of Lexpert's top-ranked lawyers specializing in banking and financial institutions.
Under the Liquidity Principles guideline released by the OSFI, liquidity is the capacity of an entity or financial institution to acquire sufficient cash and its equivalent (such as other tangible or intangible assets) in a timely manner and at a reasonable price to address its current liabilities and obligations as they become due. Liquidity also refers to the ability of the entity or financial institution to fund new or emerging business opportunities.
Thus, management of liquidity risks – defined as the potential loss that an institution may incur during a financial distress, whether external or internal in nature – is the responsibility of the managers, officers, and stakeholders of an institution.
Watch this video to learn more about the aspects of liquidity, i.e., what constitutes a liquid or an illiquid asset, what is a liquid market vs. a liquid asset, and a common liquidity formula:
To know your options in addressing illiquidity or insolvency, consult an expert in the area where you live. If you’re in Toronto, for example, contact a legal expert on insolvency and financial restructuring in Ontario.
Does illiquidity lead to insolvency?
Illiquidity will not automatically lead to a business becoming insolvent; however, when not remedied immediately, illiquidity may result in insolvency.
The main solution for illiquidity is to increase a business’s net income and cash flow. Some of the common ways to do this are through any or a combination of the following:
- by acquiring more capital through loans or lines of credit;
- by restructuring the business’s operations; and/or
- by decreasing the costs and expenses of the business
However, when illiquidity has dealt a huge blow to the business already, a business may proceed with the insolvency and bankruptcy remedies provided by Canadian law. These are outlined by the BIA and the CCAA:
- Bankruptcy Orders and Assignments (Part II, BIA)
- Commercial or Corporate Proposal or Division I Proposal (Division I, Part III, BIA)
- Consumer Proposal or Division II Proposal (Division II, Part III, BIA)
- CCAA Filing or Proceeding (Section 3 (1), CCAA)
Illiquidity does not automatically result in insolvency if quick action is taken.
However, if issues remain unsolved, illiquidity might lead to insolvency. Worse, it may even result in bankruptcy.
Have more questions regarding the difference between insolvency and illiquidity? Drop us your questions in the comment section below or ask any of the Lexpert-ranked lawyers on insolvency and financial restructuring.