Solvency and liquidity are related, but very distinct, terms that are valuable to investors. When a company is solvent, it means the company has the ability to pay its debts and liabilities over the long run. When a company is liquid, this means the company has significant cash on hand to pay short-term debts or the ability to get cash quickly. Here’s how the two concepts work.
A financial advisor can help you evaluate the health of companies whose shares you may be interested in.
What Is Solvency?
Solvency is the ability of a company to pay its long-term liabilities. A company that has the resources to pay all of its outstanding debts in full and on time is considered solvent. A company that cannot pay its debts because it has more liabilities than resources is considered insolvent.
There are several ways to measure a firm’s solvency. The most common is to compare a company’s total assets to its total liabilities. In other words, once you account for not only cash on hand but also property, investments and anything else of value, is the company worth more than its debts?
You can also assess solvency by comparing a company’s assets and cash flow against its total liabilities. In other words, based on this company’s revenues and overall financial position, will it have the money to pay its debts going forward?
It’s more difficult to assess solvency based on cash flow, in part because this requires partially speculative analysis. However, it’s also typically a more accurate way to measure a company’s health. For example, say a company takes on significant debt to fund an expansion. For a period of time this firm might have significantly more debt than assets, but as long as sales and growth remain strong it would also be misleading to consider the firm insolvent. By measuring solvency in both of the ways described above, you can get a better picture of the company’s overall health.
What Is Liquidity?
Liquidity is the ability of a company to access cash and pay its short-term obligations. Generally speaking, when investors talk about liquidity they’re referring to two concepts: First, it refers to a company’s cash on hand. How many of its bills can it pay today? Second, it refers to a company’s ability to access cash within a year. If the firm had to raise cash quickly, what would that look like?
As a result, there are two main factors when considering liquidity. The first, as noted above, is a company’s cash or cash-equivalent assets it has on hand. The second is a company’s highly liquid assets. These are assets that the business could reliably sell within a short period without taking a significant loss. Financial assets like stocks are considered highly liquid because they’re designed for quick sales while retaining their value. On the other hand, capital assets like real estate are not considered part of a liquidity calculation. You can sell off a building or a plot of land very quickly, but that usually means taking a significant loss on the sale.
If a company can access more than enough cash to pay its debts within the next year, it’s generally considered liquid. If it has little access to cash, and specifically cannot raise enough cash to pay its bills over the next 12 months, the company is considered illiquid.
Three Key Ratios
When you analyze a company for its liquidity and solvency, three ratios are particularly key. The first two below gauge liquidity, while the third gauges solvency.
Current Ratio
A firm’s current ratio compares its current assets (assets that can provide value within one year) against its current liabilities (liabilities and debts that are due within one year). This gives you a measure of the firm’s overall liquidity, meaning how a firm can respond to financial needs over the next 12 months. The current ratio is often a preferred measure of liquidity because short of financial collapse it’s relatively rare for a company to need cash in 24 hours or less. Typically, most liquidity issues are resolved over a period of months.
Quick Ratio
Investors can also analyze this using a metric called the quick ratio, which runs the same calculation but only uses cash or cash-like assets. The quick ratio is a strong measure of immediate liquidity, meaning how a firm can respond to financial needs today.
Debt-to-Equity Ratio
A firm’s debt-to-equity ratio (D/E ratio) compares how much overall value, or equity, a company has compared to its overall debts. This is a measure of solvency, as it compares the company’s total value against its total liabilities. An especially high D/E ratio signals that it might have too much debt and might struggle to pays its bills; an especially low D/E ratio signals that it may not have invested enough in its own growth. This can signal a company that will stagnate and generate less value over the long run.
Solvency vs. Liquidity
Solvency vs. liquidity is essentially a long-term vs. a short-term analysis of a company’s strength. With solvency, you’re assessing how well the company can continue operating into the future. With liquidity, you’re assessing how well the company can run its operations in the short term.
A company that is both highly solvent and highly liquid is in a strong position. This means that it has the money to keep operating over the long run (solvency) and it will have no trouble paying its immediate obligations (liquidity). A cautionary note: A company that sits on too much cash might have underinvested in its future. Remember, debt isn’t necessarily a bad thing. It’s often how companies grow.
Three Scenarios
A company that is insolvent or is only barely solvent and that has poor liquidity is in a weak position. This means that the company doesn’t have the assets to pay its bills in the long run (solvency) and that those unpaid bills will start coming due within the next 12 months (liquidity), giving the company very little time to make adjustments.
A company that has poor liquidity but strong solvency is sometimes referred to as having a cash-flow problem. Its value exceeds its debts, but it cannot convert that value into cash quickly enough to pay immediate bills. While cash-flow problems must be solved, investors don’t always need to write those companies off. As long as the underlying assets and value are strong, most solvent companies can solve cash-flow problems through short-term borrowing.
A company that has strong liquidity but poor solvency is in more trouble. This means that the firm has cash on hand to pay its immediate bills, but eventually it won’t be able to cover its debts.
The Bottom Line
Solvency measures how well a company can pay its long-term bills. If the firm has more assets and cash flow than overall debt, it is solvent. Liquidity measures how much cash a company has on hand. If the firm has enough cash and cash-like assets to pay its bills over the next 12 months, it is liquid.
Investing Tips
- Solvency and liquidity are critical issues when it comes to investment and lending. For example, when a bank issues credit one of the first things it checks is a firm’s solvency.
- A financial advisor can help you analyze which companies will make good investments. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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