Differences Between Liquidity vs Solvency
Before making any investment, it’s essential to know two factors upfront – whether this investment will maintain the company’s liquidity and whether the investment the company is making would keep the company’s solvency intact.
Many investors overwhelm themselves with the meaning of liquidity and solvency; as a result, they use these terms interchangeably. However, these two are entirely different from each other.
- Liquidity can be defined as a firm’s ability to meet the current liabilities of the current assetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc. it has. Liquidity is a short-term concept and also one of the most important ones because, without liquidity, the firm won’t be able to pay off its immediate liabilities. We use ratios like the current ratioCurrent RatioThe current ratio is a liquidity ratio that measures how efficiently a company can repay it' short-term loans within a year. Current ratio = current assets/current liabilities , quick ratioQuick RatioThe quick ratio, also known as the acid test ratio, measures the ability of the company to repay the short-term debts with the help of the most liquid assets. It is calculated by adding total cash and equivalents, accounts receivable, and the marketable investments of the company, then dividing it by its total current liabilities., and cash ratioCash RatioCash Ratio is calculated by dividing the total cash and the cash equivalents of the company by total current liabilities. It indicates how quickly a business can pay off its short term liabilities using the non-current assets. to determine the liquidity of the company.
- On the other hand, Solvency can be defined as the ability of the company to run its operations in the long run. That means solvency is a long-term concept.
And investments can affect both of these, but they are much different than each other.
Table of contents
- Liquidity refers to a company’s ability to meet its current liabilities with its current assets. This is crucial, as a company can only pay off its short-term obligations with liquidity.
- The current, quick, and cash ratios are some ratios used to evaluate a company’s liquidity. Solvency, on the other hand, is the company’s ability to sustain its operations in the long term.
- Liquidity and solvency are different concepts, with liquidity being a short-term measure and solvency being a long-term measure.
Liquidity vs. Solvency Infographics
As you can see that each of these concepts is much different. Here are the most significant differences between Liquidity vs. Solvency described below –
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Liquidity vs. Solvency Video Explanation
Liquidity and Solvency – Key differences
As you can already see, liquidity and solvency can’t be interchanged, and they are entirely different. Let’s look at the critical differences between Liquidity and Solvency –
- Liquidity can be defined as a firm’s ability to pay off its current liabilitiesIts Current LiabilitiesCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc. with its current assets. On the other hand, Solvency is an individual or a firm’s ability to pay for the long-term debt in the long run.
- Liquidity is a short-term concept. Solvency is a long-term concept.
- Liquidity can be found out by using ratios like the current ratio, quick ratio, etc. Solvency can be found out by using ratios like debt to equity ratioDebt To Equity RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. , interest coverage ratioInterest Coverage RatioThe interest coverage ratio indicates how many times a company's current earnings before interest and taxes can be used to pay interest on its outstanding debt. It can be used to determine a company's liquidity position by evaluating how easily it can pay interest on its outstanding debt., etc.
- Concept wise liquidity is a pretty low risk. Concept wise solvencySolvencySolvency of a company means its ability to meet the long term financial commitments, continue its operation in the foreseeable future and achieve long term growth. It indicates that the entity will conduct its business with ease. is quite a high risk.
- Liquidity needs to be understood to know how quickly a firm would be able to convert its current assets into cash. On the other hand, Solvency talks about whether the firm can perpetuate for a long period.
Liquidity and Solvency Comparison Table
|The basis for Comparison between Liquidity vs. Solvency||Liquidity||Solvency|
|1. Meaning||Liquidity can be defined as the ability of the firm to pay off its current liabilities with its current assets.||Solvency can be defined as the ability of the firm is to run the operations for a long period.|
|2. What it’s all about?||It’s a short-term concept of having enough cash and cash equivalentsCash And Cash EquivalentsCash and Cash Equivalents are assets that are short-term and highly liquid investments that can be readily converted into cash and have a low risk of price fluctuation. Cash and paper money, US Treasury bills, undeposited receipts, and Money Market funds are its examples. They are normally found as a line item on the top of the balance sheet asset. to pay off the current debts.||It’s a long-term concept of how well the operations of the firm would be run.|
|3. Obligations||Short-term obligations (as expected)||Long-term responsibility.|
|4. Why understand this?||To know how fast the current assets can be converted into cash.||To know whether the firm can perpetuate, again and again, year after year.|
|5. Risk||Pretty low.||Quite high.|
|6. What to look in the Balance Sheet||Current assets, current liabilities, and detailed account of every item beneath them;||Shareholders’ equity, debt, long-term assets, etc.;|
|7. Ratios used||Current Ratio, acid test ratio, etc.;||Debt to equity ratio, interest coverage ratio, etc.;|
|8. Impact on each other||If solvency is high, liquidity can be achieved within a short period.||If liquidity is high, solvency may not be achieved quickly.|
As you can see, liquidity and solvency are important concepts for business. But they can’t be used interchangeably; because they are entirely different in their nature, scope, and purpose. Liquidity can ensure whether a firm can pay off its immediate debt. On the other hand, Solvency handles long-term debt and a firm’s ability to perpetuate. Once you understand these concepts, you will be able to become prudent. You would also be able to make quick and effective decisions about the next move/s of your business.
This article has guided the top differences between Liquidity and Solvency. Here we take the differences between the two with examples, infographics, and a comparative table. You may also have a look at the following articles to learn more –