Liquidity, Solvency, and Zombies

By: Justice Clark Litle

2 weeks ago | Educational

“Free money from the Federal Reserve” sounds fantastic for stock prices. Picture a giant firehose of liquidity, just spraying cash in every direction, as the Fed expands its balance sheet by trillions.

How could U.S. companies — and stock prices — not benefit from that bonanza?

Pretty easily, that’s how.

It has to do with the difference between liquidity and solvency, and the rise of “zombie” companies.

To explain the difference between liquidity and solvency, we’ll start with these two rules of thumb:

  • Liquidity is all about cash flow.
  • Solvency is all about the balance sheet.

Before we go further, let’s quickly break down the three parts of a financial statement: The income statement, the balance sheet, and the cash flow statement.

  • The income statement tells you how much a company earns (or loses) in a given time period. You look at the revenues coming in, and the costs going out, and that tells you the company’s net income, which sums to a profit or a loss.
  • The balance sheet tells you about a company’s assets and liabilities. Maybe the company has $100 million worth of inventory — that’s an asset. Maybe the company owes $200 million in long-term debt — that’s a liability. If you take a company’s assets and subtract the liabilities, you get the equity, or net worth, of the company.
  • The cash flow statement tells you about cash coming in and going out. This is different from the income statement. A company might have income that isn’t in the form of cash, or cash flow sources that don’t count as income. If a company runs out of cash, it is likely in big trouble.

With that refresher, we can see what it means to say “liquidity is all about cash flow.”

Let’s say your business is in deep trouble and the Federal Reserve, or the government, helps you out. They give you a loan of $10 million.

That $10 million helps your liquidity, but it doesn’t help your solvency. You now have $10 million in cash, which is good for your cash flow. You can use that $10 million to pay bills, or pay employees, or buy more inventory and so on.

And yet, because the $10 million is a loan, it becomes a liability on your balance sheet. You still have to pay that money back at some point.

And if, say, your company was already $20 million in debt, the new loan means your company is now $30 million in debt. You received help in the form of cash — that is the “liquidity” part — but your balance sheet situation now looks worse. 

“Solvency” is a fancy way of saying a company, or a person, can pay their bills.

If a business is insolvent, it cannot pay its bills — which typically means it has too much debt, or it is losing too much money on a regular basis, or it has too much cash going out versus coming in. 

If the Federal Reserve lends money to an unprofitable business, all it does is prolong the inevitable.

Say that, due to low occupancy rates, a struggling hotel is losing $1 million per month. If the hotel borrows $5 million, that will be a short-term boost to liquidity. The $5 million provides temporary cash flow.

But at a loss rate of $1 million per month, in five months the loan money will be gone — and the hotel will be worse off than before, because it is still losing money, and still hard up for cash, while owing $5 million more than before.

To stay solvent, a business must turn a profit. Barring that, the business needs savings — emergency cash to cover expenses — or an inventory of assets it can sell.

A business is just like a person in that regard: To stay solvent, a person needs an income — or, alternatively, some form of savings or an asset base they can draw from.

The Federal Reserve can’t help with solvency, because the “free money” it provides comes in the form of a loan. If a company that is losing money takes out a loan, it has solved a liquidity problem — now it has some cash.

But the money-losing company hasn’t solved its solvency problem, and taking out a loan — a debt obligation that weighs down the balance sheet — has made the solvency problem worse.

So here is the thing: Because the Fed can help with liquidity, but not solvency, a whole bunch of companies who take money from the Federal Reserve (or Uncle Sam) are going to go bust anyway.

Take restaurants, for example.

  • Profit margins for full-service restaurants are historically in the low single digits, typically ranging from 2% to 5%.
  • Profit margins for national fast-food chains are significantly higher than full-service restaurants, but still low, more typically 10% to 12%.

When you think about the profit margins of a typical restaurant, asking it to run at 25% or 50% capacity is basically crazy. What is the point?

For any restaurant with profit margins of 10% or lower, running at 50% of capacity means losing money. Heck, running at 85% capacity might mean losing money.

The margins are so thin that a meaningful loss of business volume — if it lasts — means the company is not solvent. It will move forward at a loss, burning up cash as it goes. If the company borrows money, the new debt will be added to its balance sheet. The debt then makes the insolvency worse.  

This is where “zombies” come into play.

A loan can provide cash flow, but it can’t bring a company new life.

“Zombie” companies are not alive — in that they don’t turn a profit — but they aren’t dead either, because a continuous flow of loans keeps them lumbering along.

In flooding the system with money — handed out in the form of loans or used to purchase corporate debt — the Federal Reserve is thus creating a kind of Night of the Living Dead.

A great many companies that are no longer solvent, with business models that no longer function in a post-pandemic landscape, will nonetheless keep trundling along thanks to liquidity injections.

These companies, in an effort to reanimate, might then lower prices to try and win business, taking advantage of their subsidized status. Such action would then hurt non-zombie companies, which are still trying to earn a profit without the government’s help. 

The logic is fairly straightforward. If you provide an ocean of liquidity, but you don’t address solvency issues or the need for companies to fail in a free market system, you wind up with zombies. Lots of zombies.

The zombies then shuffle on, living off loans but not making profits, while clogging up the system and attempting to eat the living (via subsidized competition).

This is the path to a slow and painfully prolonged recovery, with persistent weakness and subpar economic growth for years to come.


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