Reasons for Liquidating—Partial and Complete Liquidation
There are a number of ways in which a corporation may cease to exist and a liquidation take place. The charter, if created for a fixed number of years, may expire. The state may see fit to repeal the charter in accordance with the right reserved at the time it was granted. The corporation may of its own accord surrender its charter; or the courts may decide that the corporation has forfeited its charter rights by reason of non-performance or because of some wrongful act. Failure to pay taxes due the state is an instance. The liquidation of a corporation may take place because of a consolidation resulting in loss of its original identity. In the case of a merger the merged corporation ceases to exist under the terms of the agreement made which may call for a more or less complete liquidation. Sometimes a reorganization effects the liquidation of an insolvent corporation. If the new corporation obtains the assets of the previous corporation under a forced sale, the money received would be applied to the satisfaction of the old creditors’ claims.
Insolvency is the most usual reason for liquidating a corporation. Insolvency may be either actual or legal. By the National Bankruptcy Act insolvency is defined as the condition in which the assets of a person, firm, or corporation are less than the debts. This definition emphasizes the economic point of view. A corporation is legally insolvent when the cash assets are not sufficient to pay debts when they become due. Either of these conditions may exist without necessarily disastrous results, though it generally leads to disaster sooner or later. However, the fact that these conditions do exist indicates that the business in question is not well managed. It is well, therefore, to bring out the more prevalent causes leading to insolvency.
Current Assets Transferred into Fixed Assets
A common cause of insolvency is the tying up of current assets in plant and equipment. While this may be the actual cause, the post-mortem assigns the cause generally to lack of “working capital.” When a business expands and orders are coming in in excess of the facilities at hand, there is a great temptation to put a large part of the incoming funds into plant in order to take full advantage of the opportunities in sight. The result is that eventually the point is reached where it is impossible to get the cash necessary to meet maturing obligations. While the need for plant and equipment may justify the outlay, they cannot readily be converted into cash for they are usually of such a special nature as to be of small value without the organization.
Tying up Cash in Stocks of Material
The conversion of the cash resources of a company into stocks of material is another cause of insolvency, especially if the turnover is slow or the business is of such a nature as to require large sums invested in materials. Though capital in this form is generally being converted into cash or other forms of working capital, the fact that large sums are invested in material does not always mean that its cash value measures the amount of working capital. On the liability side of the balance sheet there may be items such as short-time loans or accounts payable which must be deducted in order to determine the net working capital. If the stock carried is disproportionate to requirements, it is a sign of poor management. When this state of affairs is allowed to continue for some time, the chances are that stocks will become obsolete or deteriorate, resulting in a loss. This will eventually result in the accumulation of current liabilities or floating debts and so bring about a condition of insolvency.
Unwise Use of Cash for Paying Dividends
Dividends are sometimes paid at a rate entirely out of proportion to average earnings, or a rate is maintained that is at variance with current earnings. Profits depend to a large extent upon economic and financial conditions. Business does not move on an even level throughout the years. The rule with conservative corporations is that dividends must not be allowed to rise, even in most prosperous periods, above a conservative estimate of the average earnings. In periods of prosperity the demand on the cash resources of a business increases as the prices of material, labor, and money rise. The result is that while a company may make large profits it may not be in a position to pay more than the usual rate of dividends. Many a corporation after paying big dividends in prosperous times has ended by placing its affairs in the hands of its creditors. Dividend payments are dependent not only upon profits but to a greater extent upon the concern’s cash position. To endeavor to do a large volume of business with a small working capital is generally a sure and a quick way of landing in bankruptcy. The prudent way is to withhold dividends until in the normal course of events cash is accumulated beyond the requirements of the business. The book surplus must be reinforced by a satisfactory cash balance as a basis for the declaration of cash dividends.
Sometimes corporations may find it sound practice to pay dividends with the proceeds of temporary bank loans. This is not open to objection under certain circumstances. For example, the company’s business may be subject to wide seasonal fluctuations’ or it may be of such a nature that it nominally operates with a small working capital. Even in these cases the assumption must be that the loans can be repaid when due without any undue strain or effort. There is some question regarding the soundness of the practice, sometimes resorted to, of issuing long-term obligations or of selling additional stock for the purpose of obtaining cash to pay dividends. If the profits are extraordinarily large and the probabilities are that they will remain so, then the increased capitalization may not be a serious handicap in itself. However, where the surplus shown on the books is fictitious or when a legitimate showing of profits cannot be made, then such a transaction would clearly be fraudulent.