Difference between Liquidity vs Solvency
Liquidity refers to the firm’s ability to meet its short-term financial obligations or how quickly a firm can convert its current assets into cash.
Assets such as inventory, receivables, equipment, vehicles and real estate aren’t considered liquid as they can take many months to convert to cash. In the event of financial stress, such assets can become difficult to convert to cash at all. Stocks and marketable securities are considered liquid assets because these assets can be converted to cash in a relatively short period of time in the event of a financial emergency.
Solvency refers to the firm’s ability to meet its long-term financial obligations.
We may note, one of the primary objectives of any business is to have enough assets to cover its liabilities. This is known as solvency. Along with liquidity, solvency enables businesses to continue operating.
Assets are the things owned by the firms and liabilities are what firms owe on those assets. So, if firms have too many liabilities and not enough assets to pay those liabilities, they will face a financial crisis and eventually will not be able to continue business.
Liquidity is often confused with solvency and we may note, that both Liquidity vs Solvency terms are not interrelated, as we will discuss further that liquidity is a short-term measure while solvency is a long-term measure.
Head To Head Comparison Between Liquidity vs Solvency (Infographics)
Below is the top 8 difference between Liquidity and Solvency
Key differences between Liquidity vs Solvency
We may note, before making the investment the relevant factors that need to be looked upon is – liquidity vs solvency, as these are related measures and helps the investors to carefully examine the financial health and position of the company. Both Liquidity vs Solvency are popular choices in the market. let us discuss some of the major Difference Between Liquidity and Solvency:
- Liquidity refers to the firm’s ability to meet its current liabilities with the help of its current assets. On the other hand, solvency refers to the firm’s ability to meet its long-term debt obligations.
- Liquidity can be calculated by using ratios like current ratio, cash ratio, quick ratio/acid test ratio etc. Solvency can be calculated using ratios like debt-to-equity ratio, interest coverage ratio, debt-to-asset ratio etc.
- Liquidity is the short term concept as it relates more to short-term cash flow. On the other hand, solvency is the long terms concept, which relates more to long terms financial stability of the firm.
- Better solvency ratios indicate a more creditworthy and financially sound company in the long-term. On the other hand, liquidity ratios indicate how easy it will be for the company to raise enough cash or convert assets into cash.
- Liquidity helps to determine the current picture about the firm’s performance but solvency can determine whether the firm will remain solvent or not.
- A bad Liquidity vs solvency position should be a warning sigh to the investors, as it suggests that the company might be facing trouble to meet its short-term obligations and is struggling to fund its long-term obligations.
- 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 off its current bills.
- If a company finds that it has unexpected expenses but has high liquidity, it can easily sell some of its cash assets to pay for those expenses without facing any financial challenges. On the other hand, a company must have lower debts to ensure that they are able to reinvest in their business to expand operations, as higher debts require to pay high-interest payments which will eventually erode all the profits and firm will not remain solvent.
Liquidity vs Solvency Comparison Table
Below is the topmost comparison between Liquidity vs Solvency
|The basis Of Comparison between Liquidity vs Solvency||
|Meaning||Liquidity indicates the measure of the ability of the firm to meet its immediate current financial obligations.||Solvency indicates the firm’s ability to have sufficient assets to meet its debts in the long term.|
|Why it is important?||It tells how quickly current assets of the firm can be converted into cash.||Lack of solvency in the business may result for its liquidation, as it directly affects the firm’s day to day operations and thus the profitability.|
|Obligations||Short-term measure||Long-term measure|
|Ratios||Current ratio, cash ratio, quick ratio/acid test ratio.||Debt-to-equity ratio, interest coverage ratio, debt-to-asset ratio.|
|Operational challenges||When a firm is not able to convert its assets quickly to cash.||When a firm doesn’t have enough assets to pay off their bills (liabilities).|
|Ratio interpretation||The higher the better for a firm to meet its all current liabilities.||Higher Interest coverage ratio and lower debt-to-equity ratio, assures the probability that the firm will not default on its long-term debt obligations.|
|Basic function||To settle all current debt with all the current assets that are available.||To measure a firm’s financial health so that it could meet its debt obligations on time.|
Conclusion – Liquidity vs Solvency
In this Liquidity vs Solvency article, we have seen Both liquidity vs solvency help the investors to know whether the company is capable of covering its financial obligations or not. These ratios are used in the credit analysis of the firm by investors, creditors, suppliers, and financial institutions, in order to make a sound/profitable business decision. If the firms can remain liquid or maintains their solvency they can easily avoid drowning in debt and becoming insolvent.
As mentioned above, liquidity and solvency positions of a firm can give us a relevant snapshot of a firm’s current health and how well it is structured to meet its short and long terms obligations.
Monitoring liquidity and solvency helps us to determine whether or not a firm is taking on more debt that it can manage; it can also help determine if a firm can realistically pay off those debts in the long term.
This has a been a guide to the top difference between Liquidity vs Solvency. Here we also discuss the Liquidity vs Solvency key differences with infographics, and comparison table. You may also have a look at the following articles to learn more –