BUSINESS BLOGS
BUSINESS BLOGS
category: business
10 Jul 2008

When you enter business school, you dread accounting classes. Financial accounting is actually not bad, especially if you like finance, but managerial accounting? Please shoot me. In financial accounting, you come across two terms that seem interchangeable, but are in fact quite different: solvency and liquidity.

- Solvency is the ability to pay one’s bills.

- Liquidity is converting the value of an asset into cash.

You can try all you want, but while in school, you tend to mix up the words. But if you want to really get just how different those two things are, start a business… better yet: fund it yourself.

Trust me, you become an accounting messiah.

Anyway, ironically, when you start a company, chances are that you have some money (be it by way of savings, love money, found money, blood money, stolen money - sorry, wrong blog). On Day 1, you probably don’t have any expenses, so you are free to spend as you see fit. Of course, with nothing to show for your business apart from an idea on a beer-stained napkin, your business lacks any real value.

That, in a nutshell, captures the balance sheet equation: Shareholder’s Equity = Assets Less Liabities.

It’s simple, when you think about it, but even to this day sometimes I invert some of those variables.

So off you go, trying to take your idea from concept to reality… and as you do so, you spend cash, take on liabilities, and repeat. This is captured by the income statement, of course, whose equation is simply: Profits = Revenues Less Costs.

Much the same way that an income statement and balance sheet (along with changes in cash flow) are related financial statements; solvency and liquidity are too.

Of course, ideally, as you drain your cash reserves- sometimes too precipitously - you build equity. The problem is, the value of your project is highly intangible, subjective, and timely. Example?

Doubleclick - as a public company - was worth $1B. Yet two years later - as a private company - it was worth $3.1B. Go figure.

Doubleclick was a mature, established business. Your soiled napkin is just that… if you’re lucky to turn it into a business and create value, that’s great, but you lack liquidity in that you cannot easily convert the value you have created into cash.

In effect, the process of company building is simply trading off solvency for liquidity: on Day 1, you are solvent as you have plenty of cash to pay bills. As you take on liabilities and start to create business, you generate revenues (though oftentimes revenues are paid down the road)…

So net-net, a major growth challenge is remaining solvent… even if the value of your enterprise is soaring, because capturing the value - or equity - of your growing business and adding to your Cash balance remains a challenge.

Technically, if you are in control, you are always able to convert the value of the asset you are building into cash by simply selling… and frankly, one of biggest reasons entrepreneurs sell is their ongoing challenge to remain solvent. One can remain solvent by keeping a lid on costs… but that tends to keep a lid on growth, too… so you hurt the business even if you are trying not to.

So for this reason, some businesspeople say enough, let’s liquidate the assets, maybe that will ensure solvency moving ahead. The more impatient you are, the higher the likelihood that you will sell the asset at an actual or perceived discount.

So why is this all very ironic?

Well, at any point, you can technically sell equity and raise capital, to ensure that you remain solvent for an extended period of time… but in doing so, you tend to ensure that a liquidity transaction gets delayed, as investors coming on board will want to see a hefty return on their investment first.

At the risk of quoting Rod Stewart: have I told you, lately, how much I hate irony.