Solvency Ratio vs. Liquidity Ratios: An Overview
Liquidity ratios and the solvency ratio are tools investors use to make investment decisions. Liquidity ratios measure a company's ability to convert its assets into cash. On the other hand, the solvency ratio measures a company's ability to meet its financial obligations.
The solvency ratio includes financial obligations in both the long and short term, whereas liquidity ratios focus more on a company's short-term debt obligations and current assets.
The solvency ratio is a comprehensive measure of solvency, as it measures a firm's actual cash flow—rather than net income—by adding back depreciation and other non-cash expenses to assess the company’s capacity to stay afloat. It measures this cash flow capacity in relation to all liabilities, rather than only short-term debt. This way, the solvency ratio assesses a company's long-term health by evaluating its repayment ability for its long-term debt and the interest on that debt.
The solvency ratio is used often by prospective business lenders to discover whether a company’s cash flow is sufficient to meet its short-and long-term liabilities. The lower a company's solvency ratio, the greater the probability that it will default on its debt obligations.
In contrast to liquidity ratios, the solvency ratio measure a company's ability to meet its total financial obligations. The solvency ratio is calculated by dividing a company's net income and depreciation by its short-term and long-term liabilities. This indicates whether a company's net income is able to cover its total liabilities. Generally, a company with a higher solvency ratio is considered to be a more favorable investment.
- Liquidity ratios and the solvency ratio are tools investors use to make investment decisions.
- Liquidity ratios measure a company's ability to convert their assets to cash.
- The solvency ratio includes financial obligations in both the long and short term, whereas liquidity ratios focus more on a company's short-term debt obligations and current assets.
Liquidity ratios gauge a company's ability to pay off its short-term debt obligations and convert its assets to cash. It is important that a company has the ability to convert its short-term assets into cash so it can meet its short-term debt obligations. A healthy liquidity ratio is also essential when the company wants to purchase additional assets.
For example, internal analysis regarding liquidity ratios involves using multiple accounting periods that are reported using the same accounting methods. Comparing previous time periods to current operations allows analysts to track changes in the business. In general, a higher liquidity ratio shows a company is more liquid and has better coverage of outstanding debts.
One common liquidity ratio is the current ratio. The current ratio measures a company's ability to meet its short-term debt obligations. It is calculated by dividing its current assets by its current liabilities. Generally, a higher current ratio indicates that the company is capable of paying off all of its short-term debt obligations. Another common liquidity ratio is known as the quick ratio. It 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"
Liquidity ratio analysis may not be as effective when looking across industries as various businesses require different financing structures. Liquidity ratio analysis is also less effective for comparing businesses of different sizes in different geographical locations.