Solvency and liquidity are important to measure a company’s financial health. From liquidity, we know the ability of a company to pay it short term obligations. From solvency, we know the ability of a company to meet it long term obligations. These ratios are viewed as an indicators of cash flow problems.
A solvent company is one that owns more than it owes; in other words, it has a positive net worth and a manageable debt load. On the other hand, a company with adequate liquidity may have enough cash available to pay its bills, but it may be heading for financial disaster down the road. Solvency and liquidity are equally important, and healthy companies are both solvent and possess adequate liquidity.
Liquidity ratios gauge a company’s ability to pay off its short-term debt obligations and convert its assets to cash. It is important that a company has the ability to convert its short-term assets into cash so it can meet its short-term debt obligations. A healthy liquidity ratio is also essential when the company wants to purchase additional assets.
Current Ratio and Quick Ratio
Current ratio measures a company’s ability to pay off its current liabilities (payable within one year) with its current assets such as cash, accounts receivable and inventories. The higher the ratio, the better the company’s liquidity position.
Quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets and therefore excludes inventories from its current assets. It is also known as the “acid test ratio”.
In contrast to liquidity ratios, solvency ratios measure a company’s ability to meet its total financial obligations. The solvency ratio is calculated by dividing a company’s net income and depreciation by its short-term and long term liabilities. This indicates whether a company’s net income is able to cover its total liabilities. Generally, a company with a higher solvency ratio is considered to be a more favorable investment.
What is considered a good solvency ratio will differ from industry to industry. However, generally, a solvency ratio of 20% and higher is considered to be good. It can also be useful to calculate the solvency ratio of all your competitors. This will give you a glimpse of how you are doing compared to others.
Debt to equity and Interest coverage ratio
Debt to equity ratio indicates the degree of financial leverage being used by the business and includes both short-term and long-term debt. A rising debt-to-equity ratio implies higher interest expenses, and beyond a certain point, it may affect a company’s credit rating, making it more expensive to raise more debt.
Interest coverage ratio measures the company’s ability to meet the interest expense on its debt, which is equivalent to its earning before interest and taxes (EBIT). The higher the ratio, the better the company’s ability to cover its interest expense.
Liquidity and Solvency – Key differences
As you can already see liquidity and solvency can’t be interchanged and they are completely different from each other. Let’s look at the key differences between Liquidity and Solvency –
- Liquidity can be defined as a firm’s ability to pay off its current liabilities with its current assets. Solvency, on the other hand, is an individual or a firm’s ability to pay for the long-term debt in the long run.
- Liquidity is a short-term concept. Solvency is a long-term concept.
- Liquidity can be found out by using ratios like current ratio, quick ratio etc. Solvency can be found out by using ratios like debt to equity ratio, interest coverage ratio etc.
- Concept wise liquidity is a pretty low risk. Concept wise solvency is quite a high risk.
- Liquidity needs to be understood to know how quickly a firm would be able to convert its current assets into cash. Solvency, on the other hand, talks about whether the firm has the ability to perpetuate for long period of time.
Gitman, L.J. Principles of Managerial Finance