Liquidity ratios and solvency ratios are tools investors use to make investment decisions. Liquidity ratios measure a company's ability to convert its assets to cash. On the other hand, solvency ratios measure a company's ability to meet its financial obligations.
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.
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.
In contrast to liquidity ratios, solvency ratios 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.