You’ve started your own business, and now you keep coming across all of these financial terms in your paperwork. Profitability, solvency, liquidity… It can be hard to keep up !
In this post we are going to explore everything you need to know about solvency and liquidity, and explain how understanding these terms can help your business grow and remain in good financial health for the long-term.
While solvency and liquidity are both essential for a financially healthy business, they are entirely separate concepts.
Solvency is a company’s ability to meet their long-term debts and financial obligations, and consequently their ability to keep operating for the foreseeable future.
In order to be solvent, a company’s assets must be worth more than the sum of its debt obligations. There are various formulas that can be used to determine the solvency of a business.
Some events can put a company’s solvency at risk, such as patents expiring, changes in certain regulations that would impact profits, or being involved in a lawsuit.
Just remember, solvency is about long-term stability. Like with profitability, there are ratios that can be used to analyze a company’s solvency.
Interest Coverage Ratio
Operating income / interest expense = company’s ability to pay the interest on its debt
A higher result indicates greater solvency.
Company debt / value of its assets = whether a company has taken on too much debt
A lower result indicates greater solvency.
Solvency Ratio Formula
Solvency ratios can vary greatly by industry, so it’s important to carry out industry benchmarking when making analysis based on the solvency ratio.
(Net after-tax business income + All non-cash expenses) / (Short-term business liabilities + Long-term business liabilities)
Adjusted net income / total liabilities = Solvency ratio
When examining the financial health of a company, whatever their size, solvency often goes hand in hand with liquidity.
Liquidity is the next concept you’ll need to understand. Liquidity refers to immediately accessible funds or assets that can be easily converted into usable funds.
Stocks and Bonds
Stocks and bonds are usually considered as liquid as they have a very active market with many buyers and sellers immediately available.
Cash is normally seen as the most liquid form of payment.
Solvency, Liquidity and Bankruptcy
A company lacking liquidity can have to enter bankruptcy even if it is solvent if it cannot convert its assets into funds in order to meet financial obligations. Likewise, a company needs liquidity to pay off short-term obligations, but if it is insolvent it will become bankrupt.
To recap, start by remembering that liquidity is about short-term funds available, whereas solvency is about company value vs. company debt, for long-term commitments.You will find that understanding these terms and being able to use them properly will prove itself to be invaluable, both when communicating internally with your team and engaging with external stakeholders. Got a big meeting coming up? If you need to brush up on your profitability terminology, don’t hesitate to check out our latest post on profitability. It contains everything you need to know on profitability, margin ratios, ROA and ROI.
In conclusion, some people would argue that it’s not what you’ve got in the bank that matters at all, but a company’s staying power for the long-term and short-term usable funds. Gain invaluable insight into your company’s solvency and liquidity through all-in-one software such as Kiwili, and access key metrics such as interest coverage ratios, debt-to-assets ratios, and solvency ratios. Try our software for 14 days, free of charge!