Solvency is the ability of a company to meet its long-term debts and financial obligations. It can also be described as the ability of a corporation to meet its long-term fixed expenses and to accomplish long-term expansion and growth. This is best measured using the net liquid balance (NLB) formula. In this formula, solvency is calculated by adding cash and cash equivalents to short-term investments, then subtracting notes payable.
Solvency actually refers to a firm’s financial position over the long term. A solvent company is one that has a positive net worth their total assets are greater than their total liabilities. It is therefore a balance sheet concept. A fairly common measure related to solvency is the debt-to-equity ratio. If a company has more debt than equity, and this situation continues, they may find it difficult to service their debts and, eventually, end up insolvent unable to meet their debt obligations.
Liquidity is the ability of an organization to service its short term debts. Liquidity also refers to how easily the firm is able to transform its assets into cash. A firm that has a lot of money tied in shares of publicly held companies would be able to convert them into cash fairly quickly; a firm whose money was tied up factory equipment would have more trouble selling this for cash quickly.
The Difference between Solvency and Liquidity –
Solvency and liquidity are two ways to measure the financial health of a company, but the two concepts are distinct from each other.
Solvency, on the other hand, is the ability of the firm to meet long-term obligations and continue to run its current operations long into the future. A company can be highly solvent but have low liquidity or vice versa. However, in order to stay competitive in the business environment, it is important for a company to be both adequately liquid and solvent.
- Definition – Solvency measures the business’ ability to meet its debts as they fall due for payment
- Obligation – Long-term obligations
- What It Describes – How well the business sustains itself in the long run
- Ratios – The solvency of the business is determined by solvency ratios. These are interesting coverage ratio, debt to equity ratio and the fixed asset to net worth ratio
- Risk – The risk is extremely high as insolvency can lead to bankruptcy
- Balance Sheet – Debt, shareholders’ equity, and long-term assets
- Impact on Each Other – If liquidity is high, solvency may not be achieved quickly
Liquidity refers to the ability of a company to pay off its short-term debts; that is, whether the current liabilities can be paid with the current assets on hand. Liquidity also measures how fast a company is able to covert its current assets into cash.
- Definition – Liquidity is defined as the business’ ability to pay off current liabilities with current assets
- Obligation – Short-term liabilities
- What It Describes – How easily assets are converted to cash
- Ratios – The ratios that measure the liquidity of a business are known as liquidity ratios. These include current ratio, acid-test ratio, quick ratio, etc.
- Risk – The risk is pretty low. However, it does affect the creditworthiness of the business
- Balance Sheet – Current assets, current liabilities and detailed account of every item beneath them
- Impact on Each Other – If solvency is high, liquidity can be achieved within a short period of time
While solvency represents a company’s ability to meet long-term obligations, liquidity represents a company’s ability to meet its short-term obligations. In order for funds to be considered liquid, they must be either immediately accessible or easily converted into usable funds. Cash is considered the most liquid payment vehicle. A company that lacks liquidity can be forced to enter bankruptcy even if a solvent if it cannot convert its assets into funds that can be used to meet financial obligations.
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