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September 23, 2022
Solvency and liquidity ratios are important tools used to evaluate a business’s financial well-being. Often, the two are employed together to help entrepreneurs make better decisions about their organization’s direction and resource allocation. Potential lenders and investors may also use solvency and liquidity ratios to make decisions about a company.
While these ratios fit together hand-in-glove when determining the ability to service debt, they are independent concepts and not interchangeable. Solvency relates to a company’s long-term financial position, while liquidity relates to short-term cash flow and the business’s ability to pay off short-term debts, typically those due within a year.
Below is your guide to better understanding solvency and liquidity ratios and how each is used to assess a business’s financial stability.
Solvency | Liquidity | |
Definition | Refers to the company's capacity to have sufficient assets to meet its long-term financial commitments. | Refers to the company’s ability to meet its current financial obligations, usually within a year. |
Basic function | Measures how well a company's cash flow will cover its long-term debt. | Measures a company's ability to pay off its short-term liabilities. |
Obligations | Long term financial obligations. | Short term financial obligations. |
Associated risk | High, because if solvency ratios go up, the business may be spending too much money to fulfill long-term obligations. | Low, based on the assumption that short-term issues can be caught early. |
Common ratios | Debt-to-equity ratio; interest coverage ratio; debt-to-asset ratio. | Current ratio; cash ratio; quick ratio/acid test ratio. |
Interpretation | Higher interest coverage ratio and lower debt-to-equity ratio imply that the business is not likely to default on its long-term debt obligations. | The higher these ratios are, the better the outlook for the company to meet all current liabilities. |
Benchmark | While acceptable solvency ratios vary by industry, a solvency ratio of less than 20% or 30% is generally considered financially healthy. | A good liquidity ratio is considered anything greater than 1, indicating that the company is financially healthy. |
Importance | A business’s lack of solvency could lead to liquidation, with the company shuttering and assets sold off to pay creditors and stakeholders. | Liquidity shows how fast the company’s assets can be converted into cash, reflecting how well it manages working capital and can pay bills as they come due. |
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Let’s use some of the liquidity and solvency ratios (from the table above) to gauge the financial health of two hypothetical companies.
ABC Inc. and XYZ Ltd. both operate in the metal pipe and tube manufacturing sector, with the assets and liabilities from their balance sheets shown below.
Balance sheet (in million dollars) | ABC Inc. | XYZ Ltd. |
Cash | $5 | $1 |
Marketable securities | $5 | $2 |
Accounts receivable | $10 | $2 |
Inventory | $10 | $5 |
Current assets (a) | $30 | $10 |
Plant & equipment (b) | $25 | $65 |
Intangible assets (c) | $20 | $0 |
Total assets (a+b+c) | $75 | $75 |
Current liabilities (d) | $10 | $25 |
Long-term debt (e) | $50 | $10 |
Total liabilities (d+e) | $60 | $35 |
Shareholder’s equity | $15 | $40 |
Solvency ratios | ABC Inc. | XYZ Ltd. |
Debt-to-equity (D/E) = Total debt / Total equity | Debt to equity = $50 / $15 = 3.33 | Debt to equity = $10 / $40 = 0.25 |
Debt-to-assets = Total debt / Total assets | Debt to assets = $50 / $75 = 0.67 | Debt to assets = $10 / $75 = 0.13 |
Liquidity ratios | ABC Inc. | XYZ Ltd. |
Current ratio = Current assets / Current liabilities | Current ratio = $30 / $10 = 3.0 | Current ratio = $10 / $25 = 0.40 |
Quick ratio = (Current assets – Inventories) / Current liabilities or, Quick ratio = (Cash and equivalents + Marketable securities + Accounts receivable) / Current liabilities | Quick ratio = ($30 – $10) / $10 = 2.0 | Quick ratio = ($10 – $5) / $25 = 0.20 |
Based on the ratios computed above, we can draw some conclusions about the financial condition of these two companies.
Liquidity: ABC’s current ratio of 3 indicates a high degree of liquidity. Its quick ratio of 2 suggests adequate liquidity even after excluding inventory. For every dollar of current liability, $2 in assets can be quickly converted to cash.
Solvency: ABC’s debt to equity ratio of 3.33 shows that its debt surpasses its equity by over threefold. Its debt to assets ratio of .67 shows that two-thirds of its assets are financed by debt, reflecting that the company is highly leveraged.
Additionally, close to half of ABC’s noncurrent assets comprise intangible assets, such as goodwill and patents. As a result, its ratio of debt to tangible assets is .91 ($50 / $55), meaning over 90% of its tangible assets were financed by borrowing.
Financial health: ABC has a comfortable liquidity position but a dangerously high degree of leverage.
Liquidity: XYZ’s current ratio of 0.4 indicates an inadequate degree of liquidity. It has only $0.40 in current assets available to cover every $1 of its current liabilities. Its quick ratio of 20% indicates an even more dire liquidity position, with only 20 cents of liquid assets for every $1 of current liabilities.
Solvency: XYZ’s financial leverage appears to be at a comfortable level. Its debt-to-equity ratio of 0.25 and debt-to-asset ratio of 0.13 indicate that the company is at only 25% of equity and that only 13% of its assets are financed by debt.
Further, XYZ’s asset base consists wholly of tangible assets. Its ratio of debt to tangible assets is 13% ($10 /$75), or about one-seventh that of ABC’s 91%.
Financial health: XYZ is in a precarious liquidity position but a comfortable debt position.
• Use a combination of liquidity and solvency ratios to get a clear picture of a company’s financial health. Using only one set of ratios may provide a misleading picture.
• Solvency and liquidity ratios vary by industry. A comparative analysis of financial ratios for two or more businesses is meaningful only if they operate in the same industry.
• Instead of looking at just a year-end snapshot of solvency or liquidity, analyze how these ratios trend over time to see whether the company’s financial position is improving or deteriorating. Also, pay close attention to any negative outliers to determine whether they are the result of a one-time event or signal a weakening of business fundamentals.
Assessing solvency and liquidity ratios over time gives businesses a clearer picture of their financial standing. Monitoring these ratios on a routine basis can also inform better strategies for maximizing profit or in times of crisis, for continuing business activities.
Kanika is an enthusiastic content writer who craves to push the boundaries and explore uncharted territories. With her exceptional writing skills and in-depth knowledge of business-to-business dynamics, she creates compelling narratives that help businesses achieve tangible ROI. When not hunched over the keyboard, you can find her sweating it out in the gym, or indulging in a marathon of adorable movies with her young son.
Accounting & Finance
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