The meaning of liquidation depends on the use of the word. In financial terms, there are three different definitions of it. In economics or finance it refers to a failed company. A company that is insolvent is unable to pay its bills when they are owed. Liquidation is the process of winding up the company. The operations of the company cease at this point. The assets would then be divided up among its creditors and stock holders. This is done based on whose claims have priority.
Insolvent companies that choose to go into liquidation generally do so under U.S. bankruptcy code Chapter 7. This legal statute gives the rules on liquidation of companies. Companies that are still solvent but are in trouble may also file a Chapter 7 bankruptcy. This is less common. There are also bankruptcies for companies that do not force liquidation. One such provision that covers this scenario is Chapter 11. In a Chapter 11 filing the trustee saves the company and restructures its debts.
When the process of liquidation occurs, the company halts all operations. All of its assets are tallied up and then distributed to the various claimants. After this is finished, the trustee finally dissolves the business. The debts actually have not been discharged in this process. They still exist to the point where the statute of limitations on the debts expires. There is no debtor in existence to pay off these debts. Creditors simply write them off in practice.
The assets in this liquidation process are handled in a certain methodical way. The Department of Justice appoints a trustee. This individual supervises the process. Assets are distributed to those who have claims based on their priority. Secured creditors are first in line. This is because their loans are backed up by collateral.
The lenders are allowed to seize this collateral and then to sell it. Many times they receive far less than the actual asset value because there are limited time frames. Sometimes the assets are not enough to cover their debt. These creditors are compensated from any other liquid assets in this case.
Unsecured creditors come next in the process. In this category are holders of bonds, the IRS, and employees. Bond holders are a form of unsecured creditors. The company may owe the IRS taxes. Employees may be waiting on payroll or other money they are due. The last category to receive compensation is shareholders. If any assets are left they receive them. Preferred stock investors receive priority before the common stock holders. Usually there is nothing left for either class by the time the creditors are paid.
Another definition of liquidation surrounds huge sales. Sometimes a company needs to close out a great deal of inventory. They would do this by liquidating their inventory at deep discounts. Any company can do this. They do not have to file for bankruptcy in order to sell off inventory.
A third definition of liquidation involves closing out an investment. This generally occurs when an investors sells their holdings in exchange for cash. An individual might also liquidate out of a one position and into an opposite one. If he or she held long shares in a stock, they could instead take on the identical number of short shares.
Brokers can force liquidate trader positions in certain cases. Traders who have acted or traded recklessly with risk can have this happen. If traders’ account values drop below the minimum margin requirements they can suffer from forced liquidation as well.