Solvency vs liquidity: what is the difference?

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When evaluating the economic performance of a company, there are different ratios or measures that must be taken into account. However, none of them reflects so faithfully and accurately the economic and financial state of the company as is the liquidity and solvency Of the same.

you may be wondering what is solvency and liquidity of a company, but don't worry if you don't know what it is since in this post we are going to show you the most important aspects of both concepts.

definition of solvency

The solvency is the ability of an individual or company to meet its payment commitments with creditors, that is to say, their debts. The more payment capacity you have, the more solvent you will be. A company is not solvent when its assets are not sufficient to support its liabilities.

To evaluate the solvency In a company it is necessary to verify the existence of:

  • Cash
  • Current accounts
  • collection rights
  • Property
  • Machinery

Therefore, the solvency of a company is measured as follows:

Solvency = Total value of business assets / Value of liabilities

This rate is evaluated by measuring the total fixed or current assets of the company, between the liabilities, which results in your ability to deal with long-term debt.

To know if the company is in a good solvency ratio We can analyze three different results:

  • Value equal to 1.5: Ratio of optimum solvency, the company should not worry about anything.
  • Value less than 1.5: The company you will not be able to meet the debts short term.
  • Value greater than 1.5: Your company may have too many assets.

Types of solvency

The solvency of a company It will depend on two main factors:

  • Ability to generate sufficient financial resources.
  • Ability to pay arrears, that is, the punctuality of payments.
  • Therefore, we can say that there are two types of solvency:
  • Technical solvency: It is the solvency of an entity when it is able to generate enough cash flows from its assets to settle its liabilities.
  • effective solvency: It occurs when a company cannot pay its debts with the money generated by its activities and, therefore, must sell assets or obtain additional funds to pay its debts. That is, it will be a solvency in the short term.

Difference Between Solvency and Liquidity

Both the concept of liquidity as well as solvency reflect a company's ability to pay. You should not neglect any of these aspects if you want to prevent your company from incurring serious financial problems.

Although the solvency and liquidity are two different concepts, many times they are usually related, arguing that greater liquidity provides greater ability to pay and therefore, greater solvency. However, it is convenient to differentiate them so as not to fall into errors that lead us to make wrong financial decisions.

The main difference between both concepts is based on the fact that the liquidity measure the ability to pay in the short term, that is, the immediate commitments, while the solvency covers the long-term payment commitments.

Among other differences we can stand out:

LIQUIDITY SOLVENCY
When you own plus current assets (liquid), companies have a greater liquidity capacity. there may be solvency to the extent that they have other assets have one long-term financial stability.
ease of assets in becoming cash. The future perspectives of the company
Ratios used: the current ratio, the net working capital and the test. Ratios used: the financial leverage ratio, the debt ratio, the debt ratio and the long-term debt ratio.
If the liquidity of the company is compromised, the solvency of the business could end up being affected. When there is a clear risk of insolvency, the company could end up declaring bankruptcy.
Low risk. High risk.

Conclusion

Both the concept of solvency such as liquidity reflect a company's ability to pay. However, there are certain aspects that differentiate the two terms that you have to know how to identify.

In Alter Finance, leading consulting company that has specialized in Trade Finance and Working Capital Finance, we offer you financial advice so that your company has the best performance.

Do not doubt contact us and inform you of all services we have available. We will be happy to assist you!

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