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Running a business involves carefully controlling and managing a large set of elements that form the basis for evaluating a company's performance in a particular activity. Assessing the efficiency and profitability of any business is a complex analysis of various indicators, among which the most important are the solvency and liquidity indexes.
From this article, you will learn what a liquidity ratio and solvency ratio are and understand the distinctions between them.
The liquidity ratio reflects the amount of total assets of the organisation to the amount of short-term debt obligations the company must pay soon.
The solvency ratio shows the total amount of available capital to the amount of long-term debt obligations to be paid in the long term.
What is Liquidity Ratio?
The liquidity ratio is the coefficient of the total amount of current assets (i.e., cash and assets easily convertible into money) to the total amount of short-term liabilities (i.e., payments the company must make soon). In economic terms, this ratio shows how liquid the company is if it converts inventories and short-term receivables into cash. The ratio also shows how much cash of current assets accounts for one monetary unit of current liabilities. The calculation is based on the fact that the company repays short-term liabilities mainly at the expense of current assets. Therefore, if current assets exceed current liabilities in value, the enterprise can be considered as successfully functioning. The amount of excess is set by the current liquidity coefficient.
The liquidity ratio usually reflects the most conservative view of a company's ability to cover its liabilities, unlike many other liquidity ratios, since neither inventories nor accounts receivable are taken into account when calculating this indicator. That is, if the company has to repay all current liabilities immediately, this indicator shows the company's ability to do so without selling or liquidating other assets.
If a company's liquidity ratio is greater than 1, the company has more cash and cash equivalents than current liabilities. In this situation, the company is able to cover all short-term debts and still have available cash. A liquidity ratio below 1 sometimes indicates that a company may be experiencing financial difficulties. However, a low liquidity coefficient may be an indication of a company's specific strategy in which the company is forcibly keeping low cash reserves.
What is Solvency Ratio?
The success and efficiency of the functioning of any economic entity can be assessed on the basis of indicators that determine the stability of its activities in the current market conditions. One of these indicators is the solvency ratio, which is one of the fundamental characteristics and indicators of the financial position of a commercial organisation in a market economy. Solvency also serves as an indicator of the attractiveness of a particular organisation to external investors.
The concept of solvency, by its nature, is quite close to the concept of liquidity. Prospective solvency is guaranteed by the sufficiency of means of payment to repay obligations during the forecast period, which in turn is determined by the composition, volume, and degree of liquidity of current assets, as well as the volume, composition, and speed of maturation of current obligations to be repaid.
Thus, the solvency of the enterprise lies in its ability to repay its debt obligations in full timely. The key to solvency lies in the optimal ratio of own and borrowed funds, rational spending, and competent involvement in the organisation's activities. As mentioned above, the concepts of liquidity and solvency are closely interconnected but not identical to each other since solvency is very dependent on liquidity indicators. Therefore, liquidity is considered as its basis.
Analysis of the solvency of the enterprise is a rather complex and multistep process. The system of criteria for assessing solvency includes several particular indicators characterising solvency itself as a whole and some auxiliary indicators characterising other economic concepts but directly related to solvency. The criteria of solvency assessment are the indicators directly related to solvency and their recommended values.
The liquidity ratio and the solvency ratio are interrelated because a change in one affects a change in the other.
What is The Difference Between Liquidity Ratio and Solvency Ratio?
Liquidity and solvency are the primary assessments of the performance of any business. Although they are interconnected, they still have a number of significant differences expressed in the methods for assessing the company's overall financial well-being. Let's consider each of these coefficients as part of a comparative analysis and find out the difference between them.
The liquidity ratio is the primary metric used to assess a company's ability to manage its short-term financial obligations. This is accomplished by calculating a safety margin based on accounting ratios such as the operating cash flow ratio, current ratio and quick ratio.
In turn, the solvency ratio is one of the most important accounting metrics used to determine the ability of a business to meet its long-term debt obligations, which ultimately allows for a comprehensive assessment of the financial position of the organisation based not only on the level of net income but also indicators of actual cash flows.
When it comes to a company's debt obligations to creditors, the liquidity ratio is used to assess the amount of outstanding short-term debt obligations and has found wide application not only in traditional business but also in digital forms of cooperation. On the other hand, the solvency ratio serves as a measure of the extent to which a company is willing to repay its long-term debt obligations, which are usually large sums and are engaged to promote the business in the long term.
Type of Ratios
Each ratio is an aggregate assessment carried out by analysing certain indicators with the help of secondary indices or ratios. Thus, the liquidity ratio results from calculations based on important ratios such as current liquidity quotient, operating cash flow quotient and quick liquidity quotient. The solvency ratio is calculated based on interest coverage coefficient, debt-to-equity index and fixed assets to net worth ratio.
Regarding using the balance sheet, the primary source for assessing liquidity and solvency, the liquidity ratio calculation uses items of current assets, including accounts receivable, inventories, cash and its equivalents. Moreover, current liabilities of the company, such as interest payments and accounts payable, can be used.
To calculate the debt ratio, items reflecting the long-term assets of the organisation, such as fixed assets, are mainly used. Including total equity and long-term debt in the calculation is also very common. In this case, the items of long-term debt obligations and equity are of primary importance, as they take into account the organisation's total amount of assets and its degree of readiness to use these assets to repay debts at a certain point in time.
Liquidity and solvency indexes are the main indicators of the efficiency of the company's business process, demonstrating the company's ability to maintain a balance between the level of equity and the level of borrowed funds, which ultimately affects profitability and other important economic indicators.
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