Balancing debt is an essential part of scaling a business, let alone avoiding the risk of failure. Cash flow, including liquidity and solvency, are significant indicators of a business' health. Though often used interchangeably, these terms are different measures whose differences should be understood by every business leader.
Briefly, liquidity refers to the ability of an organization to mobilize assets and use them to fund operations, service debt or react quickly to changing market conditions. Solvency is the long-term ability of a business to serve its financial obligations.
Let us discuss the importance of liquidity and solvency for a business -- and why you should care about these moving ratios.
What is the liquidity of a business?
Liquidity is the measure of the ability of a business to convert its assets into cash. It can also be defined as the ability of a business to serve its short-term obligations.
Businesses use assets to manage their liabilities. Therefore, cash is critical for a business to manage its obligations. Hence, a business would desire to keep more liquid assets that can be converted into cash quickly.
Tangible assets are considered more liquid than intangibles. For instance, inventory is often more liquid than the goodwill or patent of a business.
Common liquidity measurement ratios include:
- Current ratio = current assets / current liabilities
- Quick ratio (or acid test) = (current assets – inventory) / current liabilities
Importance of liquidity for a business
Liquidity makes buying and selling assets easier. So, to speak of a business or a market generally, liquidity will keep the trading momentum.
Liquid assets are those which can be bought or sold without losing their market values. That's the reason cash is the most liquid asset itself. Other current assets like inventory, accounts receivable, marketable securities and prepaid expenses are all liquid assets.
Businesses must hold liquid assets (including cash) to settle their ongoing expenses. These expenses include accounts payable, inventory purchases, payroll, taxes, and so on.
When a business cannot maintain liquidity, it will need to borrow money to oblige short-term liabilities. It means its cost of debt will further increase.
Also, a business will struggle to furnish its existing debt obligations that will increase its cost of borrowing and decrease its repaying abilities.
Long-term liquidity issues can lead to serious problems for a business, including leading to bankruptcy and insolvency.
What is the solvency of a business?
Solvency refers to the ability of a business to cover its long-term liabilities. A solvent business will own more assets than liabilities.
Solvency also means repaying financial obligations in the long term. Generally, when a business owns more than it owes, it is considered a solvent business.
A convenient way of analyzing the solvency of a business is to evaluate its basic accounting equation. A solvent business will carry a positive shareholders’ equity (assets minus liabilities).
The solvency of a business can also be evaluated by analyzing the cash flow statement. If a business keeps an adequate cash balance (liquidity), it will maintain its solvency.
Key solvency measures include:
- Solvency = (net income + depreciation) / (short-term + long--term liabilities)
- Debt ratio = Total debt / total assets
- Debt-to-asset ratio = Total liabilities / total assets
Importance of solvency for a business
Analyzing solvency can help understand and mitigate the solvency risk. Solvency risk is the failure of a business to meet its financial obligations even after disposing off its assets.
Insolvency of a business is related to serving short-term and long-term debts. The solvency ratios and cash flow analysis can provide insights into a business’s ability to repay its debts.
Risks of insolvency and key solvency ratios indicating such risks can lead to the inability of a business to manage capital funding. It will also increase the cost of borrowings due to higher risks of solvency.
A business facing solvency issues would have to go through business restructuring, debt refinancing and other major changes to recover.
Liquidity vs solvency – which is more critical for a business?
In sum, a firm's ability to pay off its debts in the short-term (liquidity) and long-term (solvency) are both critical measures of business strength.
As previously noted, liquidity is simply short term solvency. Yet the relationship is rarely so simple.
A business could have plenty of cash but shaky long term prospects. For example, if they invested too heavily in new physical locations with the expectation that currently high revenues would continue and grow well into the future.
Like all metrics used to analyze business performance, no measure should be the end-all-be-all for decision-making. It’s important to review several reporting metrics regularly, including liquidity and solvency ratios. A discerning eye can make all the difference in guiding the financial health of your business.
If you're a business owner looking for a partner you can trust to help you with your financials, contact us today to learn why Focused Energy is the team for the job.