Financial Analysis – Liquidity vs. Solvency

Solvency and liquidity are financial measurements of company’s financial health. Liquidity shows company’s ability to pay Short-Term Liabilities (STL) but also company’s capability to sell Short-Term Assets (STA) quickly to raise cash. Solvency refers to a company’s capacity to meet its Long-Term Financial Commitments (STL and LTL).   A solvent company is one that owns more than it owes; in other words, it has a positive net worth and a manageable debt load. On the other hand, a company with adequate liquidity may have enough cash available to pay its bills, but it may be heading for financial disaster down the road. Solvency and liquidity are equally important, and healthy companies are both solvent and possess adequate liquidity. A number of liquidity ratios and solvency ratios are used to measure a company’s financial health, the most common of which are discussed below. (See also: What Is the Best Measure of a Company’s Financial Health?)

Liquidity Ratios

  • Current ratio = Current assets  / Current liabilities
  • Quick ratio = (Current assets – Inventories) / Current liabilities
  • Days sales outstanding (DSO) = (Accounts receivable / Total credit sales) x Number of days in sales

The current ratio measures a company’s ability to pay off its current liabilities (payable within one year) with its current assets such as cash, accounts receivable and inventories. The higher the ratio, the better the company’s liquidity position. = (Cash and equivalents + Marketable securities + Accounts receivable) / Current liabilities The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets and therefore excludes inventories from its current assets. It is also known as the “acid-test ratio.” DSO refers to the average number of days it takes a company to collect payment after it makes a sale. A higher DSO means that a company is taking unduly long to collect payment and is tying up capital in receivables. DSOs are generally calculated quarterly or annually. (To learn more, check out Liquidity Measurement Ratios.)

Solvency Ratios

  • Debt to equity = Total debt / Total equity
  • Debt to assets = Total debt / Total assets
  • Interest coverage ratio = Operating income (or EBIT) / Interest expense

This ratio indicates the degree of financial leverage being used by the business and includes both short-term and long-term debt. A rising debt-to-equity ratio implies higher interest expenses, and beyond a certain point, it may affect a company’s credit rating, making it more expensive to raise more debt. Another leverage measure, this ratio quantifies the percentage of a company’s assets that have been financed with debt (short-term and long-term). A higher ratio indicates a greater degree of leverage, and consequently, financial risk. This ratio measures the company’s ability to meet the interest expense on its debt with its operating income, which is equivalent to its earnings before interest and taxes (EBIT). The higher the ratio, the better the company’s ability to cover its interest expense. (For further reading, see Analyzing Investments With Solvency Ratios.)

Calculating Liquidity and Solvency Ratios

Let’s use a couple of these liquidity and solvency ratios to demonstrate their effectiveness in assessing a company’s financial condition. Consider two companies – Liquids Inc. and Solvents Co. – with the following assets and liabilities on their balance sheets (figures in millions of dollars). We assume that both companies operate in the same manufacturing sector, i.e. industrial glues and solvents.