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Liquidity, Solvency, and Walking Dead Companies

June 22, 2020

In the past, we’ve talked about firms that can’t service their debt without borrowing more money. These “walking dead” companies are getting new injections of life now because of the Federal Reserve’s policies and huge balance sheet expansion.

 

Let’s face it, free money from the Fed sounds great, and markets are rising accordingly. There’s a funding spigot that’s been left running and the business world is drinking from it freely.

 

How can this be bad for the economy?

 

Well, the answer lies in the difference between liquidity (the amount of cash you have along with any direct inflows) and solvency (the balance sheet, and ultimately, the ability to keep operating).

 

Say a business is in trouble. It gets a $10 million loan from the government. That injection of cash obviously helps liquidity, but it doesn’t help solvency.

 

The $10 million can be used to pay bills, compensate employees, buy inventory, and so on. But since the money is a loan, it’s a liability on the balance sheet because it must be repaid.

 

If the business was already $20 million in debt, the addition of the $10 million loan gives it $30 million of total debt. The cash influx helped liquidity, but now the balance sheet looks worse.

 

If the Fed keeps loaning to companies with solvency problems, it just delays the inevitable outcome of bankruptcy.

 

Say a hotel was losing $1 million every month. It borrows $5 million. Liquidity is up. But at a loss rate of $1 million a month, the true effect of the loan is keeping unprofitable doors open for five more months. At that point, the hotel is still losing money, has more debt, and needs cash again.

 

Solvency requires profit. The Fed can’t help with solvency, even with essentially free loans to boost liquidity.

 

So, with Fed money, many firms will still die. That’s especially true of tight-margin businesses, like restaurants, that can’t operate at full capacity. All the government money is doing is keeping them around longer.

 

We know how that turns out in zombie movies. This is the path to a slow, painful recovery with consistent weakness and little growth.

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This material has been prepared for informational and educational purposes only. It is not intended to provide, and should not be relied upon for, accounting, legal, tax or investment advice. Please consult with a professional specializing in these areas regarding the applicability of this information to your situation.

Andrew Wood, Dan Simon and Alison Slezak are Investment Advisor Representatives. Advisory services are offered through CoreCap Advisors, LLC., a Registered Investment Advisor. CoreCap Advisors, LLC and Daniel A. White & Associates, LLC are separate & unaffiliated entities. 

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