Description

To understand a company’s financial health, it’s important to look at both liquidity and solvency. These terms are related but measure different aspects:

• Liquidity tells whether a company can pay its short-term debts quickly.
  
  
• Solvency shows if a company can cover its long-term debts and remain financially stable over time.
  
  

What is Liquidity?

Liquidity is about having enough cash or easily convertible assets to pay bills and meet immediate obligations.

Key Features:

• Deals with debts due within a year
  
  
• Focuses on assets that can be turned into cash quickly
  
  
• Indicates short-term financial safety
  
  

Liquid Assets Include:

• Cash in hand
  
  
• Bank balances
  
  
• Accounts receivable (money owed by customers)
  
  
• Stocks or inventory ready for sale
  
  

Example:

A company owes ?40,000 to suppliers this month. If it has ?60,000 cash in its bank account, it is liquid because it can pay its obligations on time.

Common Liquidity Ratios:

Current Ratio

Current Ratio=Current AssetsCurrent Liabilitiestext{Current Ratio} = frac{text{Current Assets}}{text{Current Liabilities}}Current Ratio=Current LiabilitiesCurrent Assets?

A ratio above 1 indicates good liquidity.

Quick Ratio

Quick Ratio=Current Assets – InventoryCurrent Liabilitiestext{Quick Ratio} = frac{text{Current Assets – Inventory}}{text{Current Liabilities}}Quick Ratio=Current LiabilitiesCurrent Assets – Inventory?

Shows the ability to pay bills without relying on selling inventory.

What is Solvency?

Solvency measures a company’s ability to meet its long-term financial commitments. It helps determine whether a business can survive over the years.

Key Features:

• Concerned with long-term debts (more than 1 year)
  
  
• Compares total assets to total liabilities
  
  
• Indicates overall financial health
  
  

Long-Term Liabilities Include:

• Bank loans over 1 year
  
  
• Bonds or debentures
  
  
• Mortgage loans
  
  

Example:

A company owns assets worth ?2 crore and has long-term debt of ?1 crore. Since assets exceed liabilities, the company is solvent.

Common Solvency Ratios:

1. Debt-to-Equity Ratio
   
   

Debt-to-Equity=Total DebtShareholders’ Equitytext{Debt-to-Equity} = frac{text{Total Debt}}{text{Shareholders’ Equity}}Debt-to-Equity=Shareholders’ EquityTotal Debt?

Lower ratio = stronger solvency.

2. Interest Coverage Ratio
   
   

Interest Coverage=EBITInterest Paymentstext{Interest Coverage} = frac{text{EBIT}}{text{Interest Payments}}Interest Coverage=Interest PaymentsEBIT?

Indicates how easily the company can pay interest on its loans.

Key Differences Between Liquidity and Solvency

Quick Recap

• Liquidity: Ability to pay short-term debts using cash or near-cash assets.
  
  
• Solvency: Ability to meet long-term obligations and sustain operations.
  
  
• Exam Tip: Liquidity = short-term cash health; Solvency = long-term financial survival.

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