Liquidity vs Solvency

Differences Between Liquidity vs Solvency

Before making any investment, it’s important to know two factors upfront – whether this investment will maintain the liquidity of the company and whether the investment the company is making would keep the solvency of the company 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 assets 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 current ratio, quick ratio, and cash ratio to determine the liquidity of the company.
• Solvency, on the other hand, 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.

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Liquidity vs Solvency Infographics

As you can see that each of these concepts are much different. Here are the most significant differences between Liquidity vs Solvency described below –

 

Liquidity and Solvency – Key differences

As you can already see liquidity and solvency can’t be interchanged and they are completely different from each other. Let’s look at the key differences between Liquidity and Solvency –

• Liquidity can be defined as a firm’s ability to pay off its current liabilities with its current assets. Solvency, on the other hand, 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 current ratio, quick ratio etc. Solvency can be found out by using ratios like debt to equity ratio, interest coverage ratio etc.
• Concept wise liquidity is a pretty low risk. Concept wise solvency 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. Solvency, on the other hand, talks about whether the firm has the ability to perpetuate for long period of time.

Liquidity and Solvency Comparison Table

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 of time.
2.    What it’s all about?	It’s a short-term concept of having enough cash and cash equivalents 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 of time.	If liquidity is high, solvency may not be achieved quickly.

Conclusion

As you can see liquidity and solvency both are important concepts for a business. But they can’t be used interchangeably; because they are completely different in their nature, scope, and purpose. Liquidity can ensure whether a firm can pay off its immediate debt. Solvency, on the other hand, handles long-term debt and firm’s ability to perpetuate. Once you understand these concepts, you would be able to become prudent. You would also be able to make quick and effective decisions about the next move/s of your business.

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This has been a guide to top differences between Liquidity and Solvency. Here we take the differences between the two with examples, infographics, and comparative table. You may also have a look the following articles to learn more –

• What is Acid Test Ratio Formula?
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