Solvency Vs Liquidity: What’s The Difference And Why Are They Important?
A better understanding of a company’s financial health helps ensure its long-term success. Business owners and decision-makers need to be aware of the differences of solvency vs liquidity as part of this.
Many people use these terms interchangeably, but they refer to different financial aspects. Liquidity measures how easily a business can convert assets into cash to cover short-term costs.
Solvency assesses whether a company can meet long-term financial commitments and pay debts when they fall due. Both matter – and maintaining the right balance helps avoid financial instability.
Holding plenty of cash does not guarantee financial security in the long run. Similarly, a solvent business can still experience cash flow issues that require financial intervention.
This article explains the key differences, why they matter and how businesses can improve both.
What is liquidity?
What is liquidity in business? Or in other words, how quickly can a company access cash to cover short-term obligations?
A highly liquid business can pay bills, wages, and unexpected expenses without difficulty. Liquidity plays a crucial role in keeping operations running smoothly.
Without enough liquidity, businesses struggle to pay staff and suppliers on time. They may also face financial challenges that could require short-term loans or costly credit options.
Ways to improve liquidity can include but are not limited to:
- Cutting unnecessary expenses to preserve cash flow
- Speeding up invoice collections to improve cash reserves
- Considering short-term financing, such as invoice discounting, for more immediate needs
How to measure liquidity
Companies use liquidity ratios to assess their ability to meet short-term financial needs. But what are liquidity ratios?
Current ratio
Formula: Current assets ÷ current liabilities (in this context, ‘current’ means you could convert them into cash within 12 months)
This working capital ratio shows whether a business has enough assets to cover liabilities over the next 12 months.
A ratio above 1.0 usually indicates good liquidity, but industry standards vary. Some sectors require higher ratios due to longer payment cycles.
Quick ratio
Formula: (Current assets – inventory) ÷ current liabilities
This acid test ratio excludes inventory, as selling stock can take time. Rather than ‘current assets minus inventory’, you can also use ‘cash + accounts receivables + marketable securities’ instead.
A ratio below 1.0 may signal liquidity concerns. For companies holding large amounts of stock, the quick ratio offers a clearer picture of financial flexibility.
Most businesses benefit from using both ratios together to assess overall liquidity. This combined approach provides a more accurate measure of financial health.
Cash ratio
Formula: (Cash + marketable securities) ÷ current liabilities
This formula only takes into account the company’s most liquid assets, the ones most readily available to pay off any short-term obligations.
What is solvency?
Solvency determines whether a business can meet long-term financial obligations. A solvent company owns more assets than liabilities, allowing it to sustain operations and potentially expand.
Financial stability makes a company more attractive to investors and lenders. Maintaining solvency reduces the risk of major financial disruptions that could threaten business continuity.
How to measure solvency
Three very simple methods to test for insolvency include:
- The cash flow test: Is your company able to pay its debts when they fall due?
- The balance sheet test: Does your company owe more than it owns as a company?
- The legal action test: If your company has received any legal enforcement actions against it – e.g. a County Court Judgment (CCJ), this could be another strong indication of insolvency.
A winding-up petition or a statutory demand also fall into this latter category,
For more details on these, read our full guide – when is a company insolvent?
Solvency ratios help businesses assess their ability to cover long-term debts. These two ratios provide useful insights:
Solvency ratio
Formula: (Net after-tax income + non-cash expenses) ÷ (short-term liabilities + long-term liabilities)
This ratio measures whether a company generates enough cash flow to cover total liabilities. Total asset depreciation is a common example of overall non-cash expenses.
A higher solvency ratio indicates financial stability. Businesses with strong solvency ratios can also better withstand economic downturns.
Debt-to-equity ratio
Formula: Total liabilities ÷ shareholders’ equity
A high debt ratio is often a sign of the business using debt to finance its growth. Companies that are capital-intensive often have a higher debt ratio.
If a debt ratio is lower, closer to zero, this often means that the business is less dependent on borrowing to finance its operations.
Why solvency and liquidity matter
Both liquidity and solvency play a crucial role in maintaining financial health. Strong liquidity ensures that businesses can cover day-to-day costs, such as payroll and supplier payments, without issues.
Good solvency supports long-term sustainability and enables business growth. Investors and lenders assess solvency before committing funds, while liquidity influences lending decisions.
Poor liquidity can lead to missed payments and financial instability. Weak solvency increases the risk of insolvency and potential business closure.
Businesses must strike the right balance between liquidity and solvency to remain financially secure – managing both effectively reduces financial risks and improves stability.
Final thoughts: Liquidity vs solvency
We hope you found this solvency vs liquidity guide useful and for other articles, take a look through our full blog. Recent articles include an explainer on VAT penalty points and also, find out – what is an IBR (independent business review)?
If your company is insolvent, seek advice from an insolvency practitioner without delay to understand your responsibilities to creditors and business recovery options.
These options could include trying to rescue the company via a company voluntary arrangement (CVA) which lets you continue operations while settling creditor debts in regular instalments.
But if business recovery is not a viable option, then a creditors’ voluntary liquidation (CVL) is a better alternative to compulsory liquidation.
Here at Hudson Weir, our experienced insolvency practitioners and chartered accountants can assess your financial position. Contact us today for professional guidance on the best solutions for your business.
