Solvency & Liquidity

6.05.2020
|
0 Comments
||
|

Introduction to the concepts

In our daily lives, we come across these terminologies and tend to think that they mean one and the same thing. However, we must draw and bolden the razor-thin line between the two seemingly similar concepts. Their applicability and epistemology changes with their meaning. In this blog, we will be discussing the meaning of both Solvency and Liquidity. Apart from that, we will also understand what they mean in Accounting and Insurance terms.

Liquidity:

It is the ability of any firm or an organization to repay/service its short-term debts. It is usually considered for a period of 12 months or lesser. More importantly, Liquidity also refers to a situation where how easily and efficiently the firm is able to liquidate its business assets into cash.

The more the liquidity ratio a company has, the more trustworthy it becomes. The investors who are going to invest in that particular business or firm should feel a sense of security that should there be any contingency on the company, it will be able to repay the investor’s money with ease. In this way, Liquidity becomes a crucial factor where the company is evaluated by how much liquid it is.

One can calculate the liquidity by finding the current ratio (this is the ratio of the current assets, that can be expected to be converted in the next 12 months or lesser) to current liabilities (likely debts that can fall due in the next 12 months).

Solvency:

This is defined by the firm’s potential to carry on or sustain itself in the near future, all the while growing and expanding itself. Solvency stresses on the simple fact that if any company would be able to fulfill its long-term financial obligations whenever needed. In this way, solvency measures if the assets of the company are greater than its liabilities (obligations owed by the company). The balance sheet of the form reflects the financial soundness of it. Hence, Solvency becomes a major part of the sheet. Lack of solvency reflects badly on the company’s image and it wouldn’t attract investors.

Crucial differences between solvency & liquidity?

 

Basis for Comparison

Liquidity

Solvency

Definition It is defined as the ability of the business to pay off current liabilities with current assets It measures the ability of the business to meet its debts whenever required

 

Obligation Short-term liability Long-term obligation

 

What It Describes Whether the assets are easily converted to cash Whether the business can sustain itself in the long run

 

Ratios It measures the liquidity of a business and is known as the liquidity ratio. Its examples include the acid-test ratio current ratio, quick ratio, etc.

 

The solvency of the business is determined by solvency ratios. The coverage ratio, debt to equity ratio and the fixed asset to net worth ratio are few examples.

 

Risk The risk is quite low but it does affect the creditworthiness of the business

 

The risk is extremely high. So much so that insolvency can lead to bankruptcy
Balance Sheet Current assets, current liabilities and detailed account of every item beyond them

 

Equity of shareholders’ debt, and long-term assets

 

Impact on Each Other If solvency is high, liquidity can be achieved within a short period of time

 

If the liquidity is high then solvency might not be achieved quickly

 

What is Liquidity?

It is the ability of any firm or an organization to repay/service its short-term debts. It is usually considered for a period of 12 months or lesser.

What is Solvency?

This is defined by the firm’s potential to carry on or sustain itself in the near future, all the while growing and expanding itself. Solvency stresses on the simple fact that if any company would be able to fulfill its long-term financial obligations whenever needed.

How does Liquidity effect trustworthiness?

The more the liquidity ratio a company has, the more trustworthy it becomes. The investors who are going to invest in that particular business or firm should feel a sense of security that should there be any contingency on the company, it will be able to repay the investor’s money with ease.

How can Solvency attract investors?

Solvency stresses on the simple fact that if any company would be able to fulfill its long-term financial obligations whenever needed. In this way, solvency measures if the assets of the company are greater than its liabilities (obligations owed by the company). The balance sheet of the form reflects the financial soundness of it. Hence, Solvency can attract investors.

Leave a Reply

Your email address will not be published. Required fields are marked *

Share on:
Share this...
Share on Facebook
Facebook
Tweet about this on Twitter
Twitter
Share on LinkedIn
Linkedin
Website security
Contact Us