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March 09, 2022

What are Solvency and Liquidity

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Solvency vs. liquidity shows the differences between a company’s approaches to measuring the ability to use current assets to cover short-term or long-term obligations and debts.

Solvency focuses on long-term objectives. It reflects the company’s ability to generate positive net worth, and thus, meet long-term obligations. Liquidity reflects the ability to cover short-term obligations.

Keep reading the article to learn more about each method of measuring a business’s financial health.

Understanding Solvency

Solvency is the company’s ability to meet its long-term debts and any financial obligations. Solvency ratios are often used to assess an organization’s financial health since it reflects the ability to manage operations in the future.

The simplest way to measure a business’s solvency is to check the shareholders’ equity on the balance sheet. It shows the number of the company’s assets by subtracting liabilities.

Understanding Liquidity

The ability of a business to pay its liabilities on time is considered liquidity in accounting. The definition sounds similar to solvency, but these two concepts have major differences. The differences are described in the respective section of this article.

The ownership of assets and a significant or decent amount of cash are two main characteristics of the high liquidity levels of a given company. Liquidity may also refer to the ease of converting an asset into cash on short notice.

Such assets as bonds and stocks are liquid. If a business decides to sell bonds or stocks, it may do it successfully because of an active market with thousands of buyers and sellers. If a business is solvent but lacks liquidity, it may be forced into bankruptcy.

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Liquidity vs. Solvency

Businesses use both liquidity and solvency to assess their companies’ financial health. However, these two concepts are different.

Solvency is all about the company’s ability to meet long-term debts and obligations and thus to continue running business operations far into the future. A business may be highly solvent, but at the same time, lack liquidity, or vice versa.

Liquidity is about the company’s ability to meet short-term obligations and debts. If a company is liquid, it can easily pay off current liability by selling assets.

As mentioned, lack of liquidity may lead to bankruptcy even if the company’s solvency is high. However, it doesn’t mean that businesses should entirely focus on maintaining high liquidity.

Companies should aim at maintaining a healthy balance. Focusing only on liquidity may have great short-term results, but in the future, the business may face difficulties. The situation may occur due to a lack of long-term planning. That’s why solvency is also critical to a business’s financial health.

How to Assess the Solvency of a Business?

As mentioned, the easiest way to measure a business’s solvency is to calculate total assets and subtract total liabilities (shareholder’s equity). The solvency ratio measures the net income and adds amortization and depreciation. Then this total is divided by total liabilities. This ratio is mainly used by new businesses and startups.

There are other ratios that may be used to do a more detailed analysis of a company’s solvency, and thus, financial health. The interest coverage ratio uses operating income and divides it by interest expense. That way, a business owner may learn about the company’s ability to pay the interest on its debts. According to this method, a higher interest coverage reflects better solvency.

Using the “debt to assets” ratio enables you to divide a company’s debt by the value of total assets. That way, it is possible to measure solvency health and find indications (or its absence) of capital structure.

What are Solvency and Liquidity

There are other ratios a business may use to check solvency:

  • Debt to EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization);
  • debt to capital;
  • debt to shareholder’s equity;
  • debt to tangible net worth;
  • total company’s assets to shareholder’s equity;
  • total business’s liabilities to equity.

Before analyzing a company’s solvency, it’s critical to learn about solvency ratio levels by industry. That way, a company may make conclusions and take proper actions to improve its solvency.

How to Measure Company’s Liquidity?

There are three main ratios you may use to assess your company’s liquidity. These methods also help analyze how well and fast a business may liquidate its assets to meet current debts and obligations.

Current Ratio

The current ratio or a working capital ratio determines the business’s liquidity by dividing its current assets by current liabilities. The method focuses on measuring short-term assets and liabilities. In this case, “current” refers to assets and liabilities that a company has acquired in less than one year.

This method measures a business’s ability to quickly pay back all current liabilities such as debts and accounts payable. Assets that may cover liabilities are cash, inventory, accounts receivable, marketable securities.

Businesses may use industry standards to compare their ratio. The typical healthy ratio is greater than 1, meaning the company has more current sellable assets to current liabilities.

Quick Ratio

This method is also called the acid-test ratio. The method is almost identical to the current ratio, except it excludes the inventory. According to the quick ratio, inventory takes time to convert to cash, especially compared to short-term investments, cash, accounts receivable.

In simple words, inventory is not as liquid, so the business has to exclude it from the formula. It’s vital to compare your business’s results with the industry’s standards. A good ratio is when its value is greater than 1.

Operating Cash Flow Ratio

This method assesses the company’s ability to cover current liabilities with the cash flow it generates through common business operations.

The operating cash flow ratio is an indicator of a company’s short-term liquidity. According to the operating cash flow ratio, a business has to calculate the number of times it can pay off its current obligations with cash it generates during the period of given obligations.

The formula includes calculating total cash flow and then dividing it by the current liabilities. It’s a great indicator if a number is bigger since it means that the business can cover its current liabilities several times by just cash flow.

The operating cash flow ratio may be a good method to compare different periods since it shows whether the company’s ratio increases over time. If the ratio keeps decreasing, that’s a bad sign. And vice versa, if its ratio keeps gradually increasing, then it’s an indicator of excellent financial health.

Liquidity and Solvency: Main Differences

Some of the main differences between solvency and liquidity include:

  • Liquidity measures how well a company covers current liabilities with current assets (for example, cash flow). Solvency focuses on the ability to cover long-term debts.
  • Liquidity is low risk, and solvency is high since even positive ratios may lead to bankruptcy.
  • Liquidity shows how fast a business can convert its assets to cash. Solvency is all about the ability to continue to cover long-term obligations.

It’s vital to take care of the company’s liquidity, but not at the expense of avoiding solvency. Try to maintain a balance and check common ratios per industry.

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Author: Charles Lutwidge

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