What is Liquidation?
Definition: Liquidation is the process of closing down the operations of a company and selling its assets to pay off creditors and other stakeholders. A company may undergo voluntary liquidation or it may be forced to go into liquidation by the court if it is unable to meet its financial obligations.
What does Liquidation mean?
The U.S. Bankruptcy Code lays down the procedure to be followed for a company’s liquidation. Chapter 7 of the Code deals with liquidation bankruptcies. The court appoints a trustee who has the responsibility of overseeing the sale of the company’s assets. The money collected from this sale is distributed to the creditors.
Most liquidations involve a company that has been unsuccessful in running its business. By the time liquidation proceedings are initiated, it would have run up large losses and would be unable to pay its debts. When the court-appointed trustee sells the company’s assets, the money that is raised could be inadequate to pay off all the creditors and other stakeholders.
How would the money that is collected from the sale of the company’s assets be distributed? The law lays down the order in which payments are to be made. Here’s how the money that is collected would be allocated:
⇨ Secured creditors who have collateral would be paid first.
⇨ The next in line would be the unsecured creditors. Government taxes and employee payments would fall into this category.
⇨ Preferred stockholders would be paid next.
⇨ Common stockholders would receive any money that is left over.
When a company is liquidated due to insolvency, it is unlikely that the stockholders would receive any money.
At times, the word “liquidation” is used in the context of disposing of a company’s inventory. When the word is used in this manner, the company would continue to remain in operation. But the liquidation of inventory usually refers to its sale at very low prices.
Example of Liquidation
Kidsco, a toy manufacturer, has seen its sales declining in recent years. Despite the company’s best efforts, it has made losses in each of the last 14 quarters. There are a large number of unsold toys in stock and the firm’s suppliers remain unpaid for months.
The company files for bankruptcy under Chapter 7 and the court-appointed trustee takes up the task of selling Kidsco’s stocks and assets. A total of $400,000 is raised from the sale. This is distributed in the following manner.
⇨ Secured creditors’ claims are met in full. A sum of $100,000 is paid to them.
⇨ Unsecured creditors have raised claims of $550,000. The remaining $300,000 ($400,000 – $100,000) is used to pay them.
⇨ Stockholders do not receive any money at all.
Liquidation involves selling all the company’s assets to pay off creditors and other stakeholders. It usually takes place when a business is making losses and is unable to meet its financial obligations.