Solvency Ratios vs. Liquidity Ratios: What’s the Difference?

Solvency Ratios vs. Liquidity Ratios: An Overview

Solvency and liquidity are both terms that relate 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 addresses an enterprise’s ability to pay short-term obligations and a company’s capability to sell assets quickly to raise cash.

Key Takeaways

• Solvency and liquidity are both important for a company’s financial health and an enterprise’s ability to meet its obligations.
• Liquidity refers to both an enterprise’s ability to pay short-term bills and debts and a company’s capability to sell assets quickly to raise cash.
• Solvency refers to a company’s ability to meet long-term debts and continue operating into the future.
• Several ratios fall into each of these categories.

Liquidity Ratios

A company with adequate liquidity will have enough cash available to pay its ongoing bills in the short run. These are some of the most popular liquidity ratios.

Current ratio

$begin{aligned}&text{Current ratio}=frac{text{Current assets}}{text{Current liabilities}}end{aligned}$

​Current ratio=Current liabilitiesCurrent assets​​

The current ratio measures a company’s ability to pay off its current liabilities, those that are payable within one year, with its current assets including cash, accounts receivable, and inventories. The higher the ratio, the better the company’s liquidity position.

Quick ratio

$begin{aligned}&text{Quick ratio}=frac{text{Current assets}-text{Inventories}}{text{Current liabilities}}end{aligned}$

​Quick ratio=Current liabilitiesCurrent assets−Inventories​​

or:

$begin{aligned}&text{Quick ratio}=frac{text{Cash and equivalents}+text{Marketable securities}+text{Accounts receivable}}{text{Current liabilities}}end{aligned}$

​Quick ratio=Current liabilitiesCash and equivalents+Marketable securities+Accounts receivable​​

The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets. It therefore excludes inventories from its current assets. It’s also known as the “acid-test ratio.”

Days sales outstanding (DSO)

$begin{aligned}&text{Days sales outstanding (DSO)}=frac{text{Accounts receivable}}{text{Total credit sales}}timestext{Number of days in sales}end{aligned}$

​Days sales outstanding (DSO)=Total credit salesAccounts receivable​×Number of days in sales​

Days sales outstanding (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 the company is taking unduly long to collect payment and is tying up capital in receivables. DSOs are generally calculated quarterly or annually.

Solvency Ratios

A solvent company is one that owns more than it owes. It has a positive net worth and a manageable debt load. Liquidity ratios focus on a firm’s ability to meet short-term obligations but solvency ratios consider a company’s long-term financial wellbeing.

These are some of the most popular solvency ratios.

Debt-to-equity (D/E)

$begin{aligned}&text{Debt to equity}=frac{text{Total debt}}{text{Total equity}}end{aligned}$

​Debt to equity=Total equityTotal debt​​

The debt-to-equity (D/E) ratio indicates the degree of financial leverage (DFL) 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 it may affect a company’s credit rating beyond a certain point, making it more expensive to raise more debt.

Debt-to-assets

$begin{aligned}&text{Debt to assets}=frac{text{Total debt}}{text{Total assets}}end{aligned}$

​Debt to assets=Total assetsTotal debt​​

The debt-to-assets ratio is another leverage measure that gauges the percentage of a company’s assets that have been financed with short-term and long-term debt. A higher ratio indicates a greater degree of leverage and consequently financial risk.

Interest coverage ratio

$begin{aligned}&text{Interest coverage ratio}=frac{text{Operating income (or EBIT)}}{text{Interest expense}}end{aligned}$

​Interest coverage ratio=Interest expenseOperating income (or EBIT)​​

The interest coverage ratio measures the company’s ability to meet the interest expense on its debt 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.

Special Considerations

These ratios vary widely from industry to industry. A comparison of financial ratios for two or more companies would only be meaningful if they operated in the same industry.

It’s also necessary to evaluate trends. Analyzing these ratios over time will allow you to see if the company’s position is improving or deteriorating. Pay particular attention to negative outliers to see if they’re the result of a one-time event or indicative of a worsening of the company’s fundamentals.

Solvency and liquidity are equally important and healthy companies are both solvent and possess adequate liquidity. Several liquidity ratios and solvency ratios are used to measure a company’s financial health.

Solvency Ratios vs. Liquidity Ratios: Examples

Let’s use some of these liquidity and solvency ratios to demonstrate their effectiveness in assessing a company’s financial condition.

Consider two hypothetical companies, Liquids Inc. and Solvents Co., with the following assets and liabilities on their balance sheets. Figures are in millions of dollars. We assume that both companies operate in the same manufacturing sector: industrial glues and solvents.

*We assume that “current liabilities” only consist of accounts payable and other liabilities in our example with no short-term debt. Both companies are assumed to have only long-term debt so this is the only debt included in the solvency ratios shown below. It would be added to long-term debt when computing the solvency ratios if they did have short-term debt which would show up in current liabilities.

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

Liquids Inc. has a high degree of liquidity. It has $3 of current assets for every dollar of current liabilities based on its current ratio. 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. Financial leverage based on its solvency ratios appears quite high, however.

Debt exceeds equity by more than three times. Two-thirds of assets have been financed by debt. Close to half of non-current assets consist of intangible assets such as goodwill and patents. The ratio of debt to tangible assets is calculated as ($50 / $55) is 0.91 as a result so over 90% of tangible assets such as plant and equipment and inventories have been financed by borrowing. Liquids Inc. has a comfortable liquidity position but a dangerously high degree of leverage.

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

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

Solvents Co. is in a different position. This company’s current ratio of 0.4 indicates an inadequate degree of liquidity with only $0.40 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. Financial leverage appears to be at comfortable levels, however, with debt at only 25% of equity and only 13% of assets financed by debt.

The company’s asset base consists wholly of tangible assets. Solvents Co.’s ratio of debt to tangible assets is about one-seventh that of Liquids Inc., approximately 13% vs. 91%. Solvents Co. is in a dangerous liquidity situation but has a comfortable debt position.

Important

A liquidity crisis can arise even in healthy companies if circumstances come about that make it difficult for them to meet short-term obligations such as repaying their loans and paying their employees.

Solvents Co. has a looming cash crunch but 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. isn’t facing an imminent problem but it could soon find itself hampered by its huge debt load and it may need to take steps to reduce debt as soon as possible.

Example of a Liquidity Catastrophe

The best example of such a far-reaching liquidity catastrophe is the global credit crunch of 2007–09. Commercial paper, short-term debt that’s 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. This hastened the demise of giant corporations such as Lehman Brothers and the bankruptcy of General Motors (GM).

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

The Effect of Insolvency

Insolvency 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.

What Are Solvency Ratio Types?

Solvency ratio types include debt-to-assets, debt-to-equity (D/E), and interest coverage.

What Are Liquidity Ratio Types?

Liquidity ratio types include current ratio, days sales outstanding (DSO), and quick ratio.

How Do Solvency and Liquidity Apply to Companies?

A solvent company owns more than it owes with a positive net worth and a manageable debt load. A company with adequate liquidity will have enough cash to pay ongoing bills in the short term.

The Bottom Line

Solvency and liquidity are both vital for a company’s financial health and its ability to meet its obligations. Liquidity refers to both a firm’s ability to pay short-term bills and debts and its capability to sell assets quickly to raise cash. Solvency refers to an enterprise’s ability to meet long-term debts and continue operating into the future.

Some key points should be considered when using solvency and liquidity ratios. They include using both sets of ratios to get the complete picture of a company’s financial health. Making this assessment based on just one set of ratios may provide a misleading depiction of its finances.