What is liquidation?
Liquidation in finance and economics is the process of terminating a business and distributing its assets to applicants. This is an event that usually occurs when a business is insolvent, which means that it cannot pay its obligations as they fall due. At the end of the company’s activities, the remaining assets are used to pay creditors and shareholders, depending on the priority of their claims. The general partners are subject to liquidation.
Key points to remember
- The term liquidation in finance and economics is the process of terminating a business and distributing its assets to applicants.
- A bankrupt company no longer exists once the liquidation process is complete.
- Liquidation can also refer to the process of selling inventory, usually with large discounts.
How liquidation works
Chapter 7 of the US Bankruptcy Code governs liquidation procedures. Solvent companies can also apply for Chapter 7, but this is rare. Not all bankruptcies involve liquidation; Chapter 11, for example, deals with the rehabilitation of the bankrupt business and the restructuring of its debts. The business no longer exists once the liquidation process is complete.
Unlike the Chapter 7 bankruptcy declaration, trade debts still exist. The debt will remain until the expiration of the limitation period, and since there is no longer a debtor to pay what is due, the debt must be written off by the creditor.
Asset allocation during liquidation
The assets are distributed based on the priority of claims from the various parties, with a trustee appointed by the United States Department of Justice overseeing the process. The highest claims belong to secured creditors who have a guarantee on business loans. These lenders will seize the collateral and resell it, often at a significant discount, due to the short lead times involved. If this does not cover the debt, they will recover the balance of the company’s remaining liquid assets, if any.
Next are unsecured creditors. These include bondholders, government (if liable for taxes) and employees (if they owe unpaid wages or other obligations).
Finally, the shareholders receive all the remaining assets, in the unlikely event that there are any. In such cases, investors in the preferred shares have priority over the holders of common shares. Liquidation can also refer to the process of selling inventory, usually with large discounts. It is not necessary to file for bankruptcy to liquidate the inventory.
Liquidation can also designate the act of exit from a securities position. Simply put, it means selling the position for money; another approach is to take an equal but opposite position in the same title, for example by shorting the same number of actions that make up a long position in an action. A broker may forcibly liquidate a trader’s positions if his portfolio has fallen below the margin requirement, or if he has shown a reckless approach to risk taking.