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
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| Obligation | Short-term liability | Long-term obligation
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| What It Describes | Whether the assets are easily converted to cash | Whether the business can sustain itself in the long run
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| 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.
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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.
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| Risk | The risk is quite low but it does affect the creditworthiness of the business
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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
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Equity of shareholders’ debt, and long-term assets
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| Impact on Each Other | If solvency is high, liquidity can be achieved within a short period of time
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If the liquidity is high then solvency might not be achieved quickly
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