Liquidity is a company’s ability to meet its financial needs in an immediate short period. This also includes its ability to convert assets owned into cash. This may be easy or difficult, depending on the type of assets held. For example, a firm with sizable ownership of shares in the stock market is more liquid than one with land-based assets like buildings, vehicles, and equipment.
Therefore, if we analyze liquidity, we incorporate factors such as the ability to pay salaries, pay the debt, pay for rented premises, and other responsibilities. It follows, therefore, that a firm with low liquidity can still be susceptible to becoming bankrupt.
In contrast, solvency is a company’s ability to take care of its financial responsibilities over the long term. This also includes its status after subtracting the value of its assets from its liabilities. This should also incorporate all debts and interest payments.
A company runs into solvency risk when it cannot fully pay its debts and meet its other financial responsibilities after selling all of its assets.
Once a company becomes insolvent, it cannot remain afloat in the absence of a bailout.
Such a company, therefore, can potentially become bankrupt. Solvency, therefore, is a crucial factor to incorporate whenever you intend to invest.
Differences
Liquidity is a company’s ability to offset all its immediate financial needs. Solvency is an evaluation of a company’s financial state after incorporating the effect of its long-term debts burden over the long-term.
We obtain liquidity and solvency through different ratios. We calculate solvency using interest coverage, debt-to-asset, and debt-to-equity ratios.
In contrast, liquidity is obtained by working out cash ratio, acid-test ratio, and current ratio.
The solvency ratio shows us the actual financial state of a company and enables us to assess its ability to grow beyond its existing financial responsibilities.
Liquidity depicts how easy or difficult it is for a company to convert its assets into cash. Investors interested in the long-term financial status of a company evaluate its level of solvency before deciding on whether to invest. On the other hand, if they are interested in its short-term position, they will look at liquidity.
In this respect, the two concepts can influence investment differently.
High solvency implies an enterprise is able take care of its long-term debts and that the value of its assets outweighs its liabilities. In contrast, when it has high liquidity, it means that it can comfortably cater to financial responsibilities for a long time to come.
Liquidity does not tell us what the situation might be in the future. Therefore, it is advisable that if you intend to invest in a company for the long haul, you should not give too much weight to liquidity.
Liquidity ratios
Current ratio: The current ratio evaluates a company’s assets as a proportion of its current liabilities. It considers a company’s ability to offset its debts using its current assets and cash holdings. We can obtain it by dividing the value of current assets by the value of its current liabilities.
Quick ratio: Also commonly referred to as an acid test ratio, this ratio incorporates the value of a company’s inventory in assessing the financial state of a company. To calculate it, we subtract the value of the company’s inventory from its current assets and divide the answer by the value of the company’s current liabilities.
Solvency ratios
Let’s look at a few solvency ratios and their formulas.
Solvency ratio: (Net Income Depreciation) /(Short-Term Liabilities + Long-Term Liabilities)
Debt ratio: This ratio assesses a company’s financial health by determining the value of total debts as a proportion of its total assets.
Therefore, when the debt ratio rises, it increases the probability of a company defaulting. Conversely, a lower debt ratio translates into a higher level of financial security.
debt-to-asset ratio: this is an evaluation of a company’s total debt obligations as a proportion of the value of its assets. Therefore, the debt-to-asset ratio is obtained using the following formula:
debt-to-asset ratio: Total Liabilities / Total Assets
How are liquidity and solvency related?
As cited above, the two concepts are related. They both tell us how well or poorly a company is placed concerning its ability to meet its monetary responsibilities. The big point of divergence is that liquidity evaluates the short-term needs while solvency looks at the company’s positioning over a long time.
Therefore, a company’s liquidity may be high, but this does not necessarily translate into high solvency.
Conversely, a company with high solvency may have low, transitional liquidity due to reduced cash flow in the short term. Low liquidity may be caused by clients’ failure to pay invoices or delayed disbursement of approved loans. High solvency can help a company improve its liquidity within a short time through asset disposal.
Bottom line
Liquidity is just as crucial as solvency when evaluating the financial state of companies. However, their applications differ, and they should therefore not be used in isolation when making investment-related decisions. Nonetheless, they are vital instruments of assessment and can help investors decide whether to go ahead with their investment or seek other opportunities.
