Farwah Jafri | May 12 2021
Managing finances can be a very challenging task, particularly during the time of expansion when your company is constantly accruing debt. Efficient financial management not only means an organization has enough revenue to cover business expenses, but it also refers to its ability to proactively manage and mitigate its growing debt.
If you want to find out whether or not your business will be able to cover such short and long-term debts, you need to refer to the solvency vs liquidity principles and learn how they interact with the cash flow of your organization.
Solvency and liquidity refer to the capacity of a business to use existing assets to satisfy its short-term and long-term objectives, while avoiding all potential losses.
Let’s have a quick look at the difference between liquidity and solvency and see what sets these two principles apart:
Solvency refers to the long-term financial condition of a business. If your business is solvent, then it means it currently has a stable net value and holds the potential to both meet and satisfy its long-term debt goals.
Liquidity refers to a company’s ability to fulfill its short-term debt goals. A highly liquid business typically possesses large amounts of cash-equivalent assets which can be converted per necessity. Liquidity can also be considered as short-term solvency.
While they may sound like similar concepts, solvency vs liquidity is primarily the matter of managing debt from different perspectives. Understanding these terms is imperative since bankers, customers, owners, and lenders will use them to assess your company’s financial condition and decide whether or not they want to do business with you.
If you want to keep your company in a position where it can continuously generate revenue, manage debt efficiently and have investors continuously lend you money, then you need to keep your solvency and liquidity properly balanced. Thankfully, accountants have devised a number of methods through which you can determine both of these aspects for your company.
A business is referred to as ‘’solvent’’ when its total assets exceed its total liabilities, meaning it has a healthy net value and manageable debt load. Solvency ratios, as a result, help you understand the overall efficiency of your business much better than liquidity ratios because liquidity of a business can change very frequently.
There are a couple of ratios that can help you accurately analyze the total solvency of your organization.
The solvency ratio is one of the most common methods used to measure an organization’s ability to pay off both long-term and short-term debt. It is implemented by dividing your net income and depreciation items (both should be present on your income statement) by the short-term and long-term liabilities of your business (found on your balance sheet).
The debt ratio measures your company’s total assets by pitting them against its total debt. The smaller your debt ratio is, the less problematic you will seem to bankers, taxpayers, and other institutional investors. Overall, if your assets are much significant in comparison to your liabilities, you have the option to sell off some of them to cover your liabilities in worst-case scenarios.
Businesses that possess a high debt ratio are at a much higher risk of not being able to meet their financial obligations. A low leverage ratio, on the other hand, indicates that a higher percentage of a company’s investments are financed by their equity rather than their debt.
Debt-to-asset ratio is a term used to describe the ratio of debt to assets. It is similar to the debt ratio, except for the fact that here, you consider your gross liabilities rather than your total debt. Much like solvency vs liquidity, debt vs liabilities are also often mistaken, but they do not mean the same thing. Debt, primarily, applies to borrowed money, while liabilities may include various forms of other financial payments.
A helpful way to remember the difference is that while all amounts of debt can be considered as liabilities, not all liabilities can be considered debt.
Liquidity is a more short-term method of measuring your organization’s financial future. In the solvency vs liquidity debate, it is also a much more involving technique. Managing risks linked with liquidity is a critical part of a business-wide risk control system that should always be in place to help keep your operations running smoothly.
Liquidity is used to measure a company’s ability to fulfill its short-term commitments, or debts that must be paid over the next twelve months. As it is a common terminology in the business world, liquidating one’s assets means to sell them and turn them into cash, which can then be used to cover debts. So, liquidity basically tells you how quickly you can cover such debts that will be due in the next year.
There are a handful of ratios that can help you assess your company’s liquidity.
The current ratio determines if your current assets are exceeding your current liabilities. It is used to tell if a company will be able to generate enough revenue to pay all its debts if they become due. It is used by dividing an organization’s current assets (cash, accounts receivable, inventory, and prepaid expenses) by its total current liabilities (both should be present on your balance sheet).
The current ratio helps in knowing whether or not you have enough cash or liquid assets available that can be used to cover your current debt. This ratio is also widely used around the world as the primary tool to assess a company’s overall financial performance.
The quick ratio is ideal for emergency situations, and it uses only cash and accounts receivable as current assets since they are the only two assets that are readily available. It visualizes how a company can pay off short-term liabilities with all present assets apart from the inventory. The amount of cash and accounts receivable is then divided by the amount of current liabilities.
Since it does not contain any of the elements included in the current ratio, the quick ratio is a more conservative method of measuring liquidity.
You’ve drawn the comparison between liquidity vs solvency and assessed both of their metrics for your organization, and it’s highly likely that you’re not pleased with the results. So, what do you do now?
Depending on how you utilize your cash flow, whether by clearing your debts or adding more to them, greatly influences your liquidity and solvency. If your company’s solvency rates are much higher than you anticipated, then it’s recommended that you start concentrating your resources on debt repayment in the coming months.
Extra cash flow from a good month of revenue can also be used to clear debts rather than being reinvested somewhere else. Similarly, if you have exceptionally low solvency ratios, now might be a good time to start expanding your business and exploring new financial opportunities.
In the debate of solvency vs liquidity, both the principles are equally important. While they help assess an organization’s ability to cover its debts, they cannot be used interchangeably due to differences in their nature and function. However, it is important to comprehend and apply both the concepts to your business as they help you avoid late payments of liabilities, which can create serious repercussions for a company.
At the end of the day, you should not rely on a handful of metrics, rather on a wide variety of statistics and analytical reports to inform your financial planning. However, if you believe you could be partnering up with potential investors soon or are looking to borrow loan for your business, it’s a smart idea to start looking at your liquidity and solvency metrics right away to identify the financial stability of your business.
Do you own a small business and are searching for a financial partner you can rely on? Give our financial advisors a call today and explore how our range of financial management and strategic planning services can help your business achieve goals that matter to you.
Farwah is the Product Owner of Monily. She has an MBA from Alliance Manchester Business School, UK. She is passionate about helping businesses overcome challenges that hamper their growth, which is why she is working at Monily to facilitate entrepreneurs to efficiently manage business finances and stay focused on growth.