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Economy and Finance

Economy and Finance

Solvency vs Liquidity

09 Aug 2023 Zinkpot 225
Solvency vs Liquidity
  1. Solvency vs liquidity is the difference between measuring a business’ ability to use current assets to meet its short-term obligations versus its long-term focus.
  2. Solvency and liquidity are both important concepts. While both measure the ability of an entity to pay its debts, they cannot be used interchangeably as they are different in scope and purpose.
  3. Solvency refers to the business’ long-term position, meaning the business has a positive net worth and the ability to make long-term financial commitments while liquidity is the ability of a  business to meet its short-term obligations and a company’s capability to sell assets quickly to raise cash.
  4. Solvency is described as how well the business sustains itself in the long run. On the other hand, liquidity is described as how easily assets are converted into cash.
  5. The risk associated with liquidity is pretty low. However, it does affect the creditworthiness of the business, while, the risk associated with solvency is extremely high, as insolvency can lead to bankruptcy.
  6. The ratios that help to measure liquidity are known as liquidity ratios. Some of them are the current ratio, the acid test ratio, the operating cash flow ratio, etc.
  7. On the other hand, the ratios that help ascertain the level of solvency for a business are a part of the solvency ratios. These include the interest coverage ratio, the debt-to-equity ratio, the fixed asset to net worth ratio, etc.
  8. A company may be solvent, but have poor cash flow, or have plenty of cash, but shaky long-term prospects. Therefore, it’s crucial to analyze both the solvency and liquidity ratios to understand a company’s financial position.
     

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