What Is Liquidation?

What Is Liquidation?

Liquidation in finance and economics is the process of bringing a business to an end and distributing its assets to claimants. It is an event that usually occurs when a company is insolvent, meaning it cannot pay its obligations when they are due. As company operations end, the remaining assets are used to pay creditors and shareholders, based on the priority of their claims. General partners are subject to liquidation.

The term liquidation may also be used to refer to the selling of poor-performing goods at a price lower than the cost to the business or at a price lower than the business desires.

How Liquidation Works

Chapter 7 of the U.S. Bankruptcy Code governs liquidation proceedings. Solvent companies may also file for Chapter 7, but this is uncommon. Not all bankruptcies involve liquidation; Chapter 11, for example, involves rehabilitating the bankrupt company and restructuring its debts. In Chapter 11 bankruptcy, the company will continue to exist after any obsolete inventory is liquidated, after underperforming branches close, and after relevant debts are restructured.

Unlike when individuals file for Chapter 7 bankruptcy, business debts still exist after Chapter 11 bankruptcy. The debt will remain until the statute of limitations has expired, and as there is no longer a debtor to pay what is owed, the debt must be written off by the creditor.

Distribution of Assets During Liquidation

Assets are distributed based on the priority of various parties’ claims, with a trustee appointed by the U.S. Department of Justice overseeing the process. The most senior claims belong to secured creditors who have collateral on loans to the business. These lenders will seize the collateral and sell it—often at a significant discount, due to the short time frames involved. If that does not cover the debt, they will recoup the balance from the company’s remaining liquid assets, if any.

Next in line are unsecured creditors. These include bondholders, the government (if it is owed taxes), and employees (if they are owed unpaid wages or other obligations).

Finally, shareholders receive any remaining assets, in the unlikely event that there are any. In such cases, investors in preferred stock have priority over holders of common stock. Liquidation can also refer to the process of selling off inventory, usually at steep discounts. It is not necessary to file for bankruptcy to liquidate inventory. 

Liquidation of Securities

Liquidation can also refer to the act of exiting a securities position. In the simplest terms, this means selling the position for cash; another approach is to take an equal but opposite position in the same security—for example, by shorting the same number of shares that make up a long position in a stock.

A broker may forcibly liquidate a trader’s positions if the trader’s portfolio has fallen below the margin requirement, or they have demonstrated a reckless approach to risk-taking.

Example of Liquidation

Company ABC has been in business for 10 years and has been generating profits throughout its run. In the last year, however, the business has struggled financially due to a downturn in the economy. It has reached a point where ABC can no longer pay any of its debts or cover any of its expenses, such as payments to its suppliers.

ABC has decided that it will close up shop and liquidate its business. It enters into Chapter 7 bankruptcy and its assets are sold off. These include a warehouse, trucks, and machinery with a total value of $5 million. Currently, ABC owes $3.5 million to its creditors and $1 million to its suppliers. The sale of its assets during the liquidation process will cover its obligations.

The Bottom Line

When a company becomes insolvent, meaning that it can no longer meet its financial obligations, it undergoes liquidation. Liquidation is the process of closing a business and distributing its assets to claimants.

The sale of assets is used to pay creditors and shareholders in the order of priority. Liquidation is also used to refer to the act of exiting a securities position, usually by selling the position for cash.