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What is Solvency vs Liquidity?

June 12, 2024

Solvency vs liquidity is the difference between measuring a business’ ability to use current assets to meet its short-term obligations versus its long-term focus. Solvency refers to the business’ long-term financial position, meaning the business has positive net worth and ability to meet long-term financial commitments, while liquidity is the ability of a business to meet its short-term obligations.

What this article covers:

What Does Liquidity Mean in Accounting?

How Do You Assess Solvency?

What Is the Difference Between Solvency and Liquidity?

What Does Liquidity Mean in Accounting?

In accounting, liquidity refers to the ability of a business to pay its liabilities on time. Current assets and a large amount of cash are evidence of high liquidity levels.

It also refers to how easily an asset can be converted into cash on short notice and at a minimal discount. Assets such as stocks and bonds are liquid since they have an active market with many buyers and sellers. Companies that lack liquidity can be forced into bankruptcy even if it’s solvent.

How Do You Assess Solvency?

Solvency refers to the business’ long-term financial position. A solvent business is one that has positive net worth – the total assets are more than the total liabilities

Solvency is assessed using solvency ratios. These ratios measure the ability of the business to pay off its long-term debts and interest on debts.

WHAT IS SOLVENCY RATIO FORMULA?

The formula for the solvency ratio is:

(Net after-tax income + Non-cash expenses) / (Short-term liabilities + Long-term liabilities)

Calculate the approximate cash flow generated by business by adding the after-tax business income to all the non-cash expenses.

Add the short-term and long-term business liabilities.

Divide the adjusted net income by the total liabilities.

WHAT IS SOLVENCY RISK?

Solvency risk is the risk that the business cannot meet its financial obligations as they come due for full value even after disposal of its assets. A business that is completely insolvent is unable to pay its debts and will be forced into bankruptcy. Investors should examine all the financial statements of a company to make certain the business is solvent as well as profitable.

What Is the Difference Between Solvency and Liquidity?

Basis for Comparison	Liquidity	Solvency
Definition	Liquidity is defined as the business’ ability to pay off current liabilities with current assets	Solvency measures the business’ ability to meet its debts as they fall due for payment
Obligation	Short-term liabilities	Long-term obligations
What It Describes	How easily assets are converted to cash	How well the business sustains itself in the long run
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.	The solvency of the business is determined by solvency ratios. These are interest coverage ratio, debt to equity ratio and the fixed asset to net worth ratio
Risk	The risk is pretty low. However, it does affect the creditworthiness of the business	The risk is extremely high as insolvency can lead to bankruptcy
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

Solvency and liquidity are both important concepts. While both measure the ability of an entity to pay its debts, they cannot be used interchangeably as they are different in scope and purpose.

However, it’s important to understand both these concepts as they deal with delays in paying liabilities which can cause serious problems for a business.

Customers and vendors may be unwilling to do business with a company that has financial problems. In extreme cases, a business can be thrown into involuntary bankruptcy.