What’s the difference between liquidity and solvency?
'Liquidity' and 'solvency' are terms that every small business owner should know. Yet like many terms that are similar in meaning, remembering which is which can be difficult. Here we run over what the two words mean, give some examples of how they're related and why one doesn't necessarily tell you much about the other.
What is solvency?
Solvency refers to a firm's financial position over the long term. A solvent company is one that has positive net worth – their total assets are greater than their total liabilities.
Solvency is therefore a balance sheet concept. A fairly common measure related to solvency is the debt-to-equity ratio. If a company has more debt than equity, and this situation continues, they may find it difficult to service their debts and, eventually, end up insolvent – unable to meet their debt obligations.
What is liquidity?
Liquidity is the ability of an organisation to service its short term debts. You can think of it as solvency but on a smaller timescale – can the business meet its debt obligations over the next 12 months?
Liquidity also refers to how easily the firm is able to transform its assets into cash. A firm that has a lot of money tied in shares of publicly held companies would be able to convert them into cash fairly quickly; a firm whose money was tied up factory equipment would have more trouble selling this for cash quickly.
Liquidity is the ability of an organisation to service its short term debts.
You can calculate a firm's liquidity by finding the current ratio – the ratio of current assets (assets you expect to converted to cash in the next 12 months: maturing bonds, accounts receivable etc) to current liabilities (debts that fall due within the next 12 months). A company with a high current ratio (more assets than liabilities) will be able to pay their short term debts comfortably. A low current ratio suggest debt servicing will be more difficult without other sources of finance.
How are solvency and liquidity related?
As stated previously, liquidity is simply short term solvency. Yet the relationship between the two is not always so simple.
A company could, for example, be solvent in so far as their balance sheet is healthy, but have poor cash flow because of problems securing short-term financing or being paid by customers they've invoiced.
On the other hand, a company could have plenty of cash but shaky long term prospects if they invested heavily in physical capital in the expectation that currently high revenues would continue and grow into the future.
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