Solvency relative to liquidity is the distinction between the long-term focus between a company’s capacity to use its existing assets to deal with its short-term obligations. Solvency means the company’s long-term financial position, which means that the company has good net equity and the potential to meet long-term financial obligations.
“Liquidity” and “solvency” are words that every small business owner should understand. However, like certain words that have a similar sense, it is hard to recall. We go through what the two words say and explain how they apply to each other and if they are related.
What this article covers:
- What Does Liquidity Mean in Accounting?
- How do you assess Solvency?
- What is Solvency Risk?
- What Is the Difference Between Solvency and Liquidity?
What Does Liquidity Mean in Accounting?
Liquidity or accounting liquidity is the term used to describe the ease of converting an asset into cash, regardless of impacting its market value. In other words, this measures debtors’ ability to pay their debts when they are owing.
What, then, are liquid accounting assets? The more “liquid” that the investment is considered to be, the easier it is to sell the investment at a fair price. Of course, cash is the liquid asset, and property or land is the least liquid asset because it takes weeks or months to sell or even years.
Assets such as stocks and bonds are liquid, as many buyers and sellers are active on the market. Organizations that lack liquidity, even if solvent, can be forced to file for bankruptcy.
How Do You Assess Solvency?
Solvency refers to a company’s long-term financial position. A solvent company has a positive net value – its total assets exceed its total liabilities.
Therefore, solvency is a concept of a balance sheet. The debt-to-equity ratio is a relatively common measure of solvency. If a company has more debt than capital equities, and this is still the case, it may not meet its obligations to handle its debts and ultimately end in insolvency.
What is the Solvency ratio formula?
Net after-tax income + Non-cash expenses
Short-term liabilities + Long-term liabilities
Other popular solvency ratios include:
Debt to Equity:
Debt to equity = Total debt / Total equity
This ratio illustrates the business’s financial leverage level, which encompasses both short and long-term debt. A rising debt-to-equity ratio means higher interest costs and, at a certain point, will impact the credit rating of a business, making the raising of more debt more costly.
Debt to Assets:
Debt to assets = Total debt / Total assets
Another leverage calculation is quantifying a debt-funded proportion of a company’s assets (short-term and long-term). A higher ratio suggests a higher debt and, thus, financial risk.
Interest Coverage Ratio:
Interest coverage ratio = Operating income (or EBIT) / Interest expense
This calculation tests the company’s capacity to meet its debt interest cost equal to its Earnings before Interest and Taxes (EBIT). The greater the ratio, the higher the capacity of the firm to pay its interest expenses.
What is Solvency Risk?
Solvency risk means that, even though its properties are disposed of, a business would not meet its financial obligations because they are due on maximum valuation. An entirely insolvent corporation cannot pay its obligations and is compelled to go bankrupt. Investors can look at all its financial statements to ensure the company is solvent and efficient.
What Is the Difference Between Solvency and Liquidity?
|Basis for comparison||Liquidity||Solvency|
|Meaning||Liquidity is characterized as the ability of businesses to fund current liabilities with existing assets.||Solvency evaluates the capacity of the business to pay its obligations when payment is due|
|What is it all about?||it’s a short term concept of having enough cash/cash equivalents to pay off the current debts||It is a long term concept of how well the operations of the firm would be run|
|Obligations||Short-term obligations (as expected)||Long-term responsibility|
|Why understand this?||How easily assets are converted to cash||How well the business sustains itself in the long run|
|Ratios used||The current ratio, acid-test ratio, etc.||Debt to equity ratio, interest coverage ratio, etc.|
|Risk||Pretty low||Extremely high|
|Balance sheet||Current assets, current liabilities, and detailed account of every item beneath them||Debt, shareholders’ equity, and long-term assets|
|Impact on each other||If solvency is high, liquidity can be achieved within a short period of time||If liquidity is high, solvency may not be achieved quickly|
Both are major terms, solvency and liquidity. While both calculate an entity’s ability to pay its obligations, they cannot be used interchangeably, since their scope and intent are distinct.
It is still necessary to consider these two principles in dealing with delays in paying obligations that can create significant problems for an organization.
Customers and retailers may not be able to work with a business with financial difficulties. In severe situations, a corporation can be plunged into unintentional bankruptcy.
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