Financial Analysis: Solvency Vs. Liquidity Ratios

By Investopedia Staff AAA

Solvency and liquidity are both terms that refer to an enterprise’s state of financial health, but with some notable differences. Solvency refers to an enterprise's capacity to meet its long-term financial commitments. Liquidity refers to an enterprise’s ability to pay short-term obligations; the term also refers to its capability to sell assets quickly to raise cash. 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 financial ratios are used to measure a company’s liquidity and solvency, the most common of which are discussed below.

Liquidity Ratios

  • Current ratio = Current assets  / Current liabilities

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.

  • Quick ratio = (Current assets – Inventories) / Current liabilities

                 = (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.”

  • Days sales outstanding = (Accounts receivable / Total credit sales) x Number of days in sales

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.

Solvency Ratios

  • Debt to equity = Total debt / Total equity

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.

  • Debt to assets = Total debt / Total assets

Another leverage measure, this ratio measures 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.

  • Interest coverage ratio = Operating income (or EBIT) / Interest expense

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.

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.

 

Balance Sheet (in millions of dollars)

Liquids Inc.

Solvents Co.

Cash

$5

$1

Marketable securities

$5

$2

Accounts receivable

$10

$2

Inventories

$10

$5

Current assets (a)

$30

$10

Plant & equipment (b)

$25

$65

Intangible assets (c)

$20

$0

Total assets (a + b + c)

$75

$75

Current liabilities* (d)

$10

$25

Long-term debt (e)

$50

$10

Total liabilities (d + e)

$60

$35

Shareholders’ equity

$15

$40

*In our example, we assume that “current liabilities” only consist of accounts payable and other liabilities, with no short-term debt. Since both companies are assumed to have only long-term debt, this is the only debt included in the solvency ratios shown below. If they did have short-term debt (which would show up in current liabilities), this would be added to long-term debt when computing the solvency ratios.

Liquids Inc.

Current ratio = $30 / $10 = 3.0

Quick ratio = ($30 – $10) / $10 = 2.0

Debt to equity = $50 / $15 = 3.33

Debt to assets = $50 / $75 = 0.67

 

Solvents Co.

Current ratio = $10 / $25 = 0.40

Quick ratio = ($10 – $5) / $25 = 0.20

Debt to equity = $10 / $40 = 0.25

Debt to assets = $10 / $75 = 0.13

 

Scenario Analysis – Comparing Ratios  

We can draw a number of conclusions about the financial condition of these two companies from these ratios.

Liquids Inc. has a high degree of liquidity. Based on its current ratio, it has $3 of current assets for every dollar of current liabilities. Its quick ratio points to adequate liquidity even after excluding inventories, with $2 in assets that can be converted rapidly to cash for every dollar of current liabilities. However, financial leverage based on its solvency ratios appears quite high. Debt exceeds equity by more than three times, while two-thirds of assets have been financed by debt. Note as well that close to half of non-current assets consists of intangible assets (such as goodwill and patents). As a result, the ratio of debt to tangible assets – calculated as ($50/$55) – is 0.91, which means that over 90% of tangible assets (plant and equipment, inventories, etc.) have been financed by borrowing. To summarize, Liquids Inc. has a comfortable liquidity position, but it has a dangerously high degree of leverage.

Solvents Co. is in a different position. The company’s current ratio of 0.4 indicates an inadequate degree of liquidity with only 40 cents of current assets available to cover every $1 of current liabilities. The quick ratio suggests an even more dire liquidity position, with only 20 cents of liquid assets for every $1 of current liabilities. But financial leverage appears to be at comfortable levels, with debt at only 25% of equity, and only 13% of assets financed by debt. Even better, the company’s asset base consists wholly of tangible assets, which means that Solvents Co.’s ratio of debt to tangible assets is about one-seventh that of Liquids Inc. (approximately 13% vs. 91%). Overall, Solvents Co. is in a dangerous liquidity situation, but it has a comfortable debt position.

Liquidity Crisis and Insolvency Risk

A liquidity crisis can arise even at healthy companies if circumstances arise that make it difficult for them to meet short-term obligations such as repaying their loans and paying their employees. The best example of such a far-reaching liquidity catastrophe in recent memory is the global credit crunch of 2007-09. Commercial paper – short-term debt that is issued by large companies to finance current assets and pay off current liabilities – played a central role in this financial crisis. A near-total freeze in the $2 trillion U.S. commercial paper market made it exceedingly difficult for even the most solvent companies to raise short-term funds at that time, and hastened the demise of giant corporations such as Lehman Brothers and General Motors.

But unless the financial system is in a credit crunch, a company-specific liquidity crisis can be resolved relatively easily with a liquidity injection, as long as the company is solvent. This is because the company can pledge some assets if required to raise cash to tide over the liquidity squeeze. This route may not be available for a company that is technically insolvent, since a liquidity crisis would exacerbate its financial situation and force it into bankruptcy.

Insolvency, however, indicates a more serious underlying problem that generally takes longer to work out, and it may necessitate major changes and radical restructuring of a company’s operations. Management of a company faced with insolvency will have to make tough decisions to reduce debt, such as closing plants, selling off assets and laying off employees.

Going back to the earlier example, although Solvents Co. has a looming cash crunch, its low degree of leverage gives it considerable “wiggle room.” One available option is to open a secured credit line by using some of its non-current assets as collateral, thereby giving it access to ready cash to tide over the liquidity issue. Liquids Inc., while not facing an imminent problem, could soon find itself hampered by its huge debt load, and it may need to take steps to reduce debt as soon as possible.

Reading Ratios – Lessons for Investors

The following points should be borne in mind when using solvency and liquidity ratios:

  • Get the Complete Financial Picture: Use both sets of ratios – liquidity and solvency – to get the complete picture of a company’s financial health, since making this assessment on the basis of just one set of ratios may provide a misleading depiction of its finances.
  • Compare Apples to Apples: These ratios vary widely from industry to industry, so ensure you’re comparing apples to apples. A comparison of financial ratios for two or more companies would only be meaningful if they operate in the same industry.
  • Evaluate the Trend: Analyzing the trend of these ratios over time will enable you to see if the company’s position is improving or deteriorating. Pay particular attention to negative outliers to check if they are the result of a one-time event or indicate a worsening of the company’s fundamentals.

Conclusion

Solvency and liquidity are both equally important for a company's financial health. A number of financial ratios are used to measure a company’s liquidity and solvency, and an investor should use both sets to get the complete picture of a company’s financial position. Additional useful information can be gleaned by comparing a company’s ratios versus its peers and by analyzing ratio trends.

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