Firm Liquidity

Liquidity is a slippery topic.  First of all, there isn't much official financial maths behind it.  Second, it often crops up in discussions differentiating organisations which are insolvent versus those which are merely illiquid.  The argument goes like this: we (the person, the firm, the market, the economy, the geographic region, the world) are in a moment described as solvent-but-illiquid (SBI).  This is a strange state to be in.  The distinction leads Walter Bagehot to suggest that, for central banks, there are certain solvent-but-illiquid moments for banks which need central bank action to provide liquidity at a cost to good banks.  This behaviour is often referred to as being the lender of last resort (LLR).

But just what is this moment?  Let us identify the other two states which a firm might find itself in as solvent-and-liquid (SAL), which one presumes is the healthy state.  Then there is insolvent, period.  It makes no sense to distinguish insolvent and illiquid from insolvent but liquid.  The state of being insolvent clearly dominates both.  This state is then I.

So we find firms mostly living in a world of SAL until the company fails and finds itself in the I state.  The bankruptcy laws of most legal jurisdictions determine the dominance of the I state.

Notice though that even here there are subtleties to the rather simplistic model above.  Corrupt firms may be allowed to survive by cronies in positions of power beyond the point of I.  There's a moral and a legal dimension to this, which is not the subject of the current posting, so let me ignore it for now.  But there's certainly a practical element here.  If by any means, fair or foul, a company can be said to still be able to function for a period while any expected independent accounting audit of its books would reasonably conclude that it is bankrupt, the point remains that firms can be 'technically' insolvent yet remain in business.  That subset of technically insolvent firms may be reasonably classified as additionally either liquid or illiquid.  So perhaps IAL and IBI are both worth considering.

Furthermore, even after a company goes bankrupt, that process itself is a period during which levels of liquidity may vary.  Measuring liquidity may not stop just because a company has been declared bankrupt.  Part of the process of restructuring, indeed, revolves around estimating the new organisation's expected short medium and long term liabilities and the new structure must aim to allow for sufficient liquidity to allow those liabilities to be met.

So in general liquidity is a valid measure across all states of the firm.  There are finally those states of a firm where the firm literally ceases to function as a firm - it simply dies as a meaningful economic entity.  Let us call that state D.  STate D is the state where liquidity no longer matters.

SAL, SBI, IBL, IAI and D are the main categories into which entities can be said to fall for the purposes of liquidity.  Next I will talk in general about liquidity and the market.