A Guide to Solvency and Liquidity
Solvency and liquidity reveal a company’s ability to meet financial obligations, both short and long term.
A View of the Company’s Financial Viability
This concept reflects a firm’s financial survival. The central question is: Can this business pay its debts? When assets exceed liabilities, the company is solvent. This indicates a solid foundation and the capacity to meet long-term commitments.
Two common solvency measures are:
- Liabilities to Equity Ratio: This ratio compares total liabilities to total equity. A high value suggests the company relies more on debt, which raises risk.
$$\text{Liabilities to Equity Ratio} = \frac{\text{Total Liabilities}}{\text{Total Stockholders’ Equity}}$$
- Interest Coverage Ratio: Also called the Times Interest Earned Ratio, this shows how easily a company can pay interest on debt. A higher number means stronger ability to cover interest.
$$\text{Interest Coverage Ratio} = \frac{\text{Net Income Before Interest and Taxes (EBIT)}}{\text{Interest Expense}}$$
Liquidity: The Short-Term Picture
Liquidity measures whether a company can meet short-term obligations with available assets. In simple terms, it looks at cash and items that can quickly turn into cash.
Two key liquidity measures are:
- Current Ratio: This compares current assets to current liabilities. A ratio above 1 means the company holds more assets than liabilities, which signals stronger short-term strength.
$$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$$
- Quick Ratio (or Acid Test Ratio): This measure is stricter. It excludes inventories and focuses on the most liquid assets. It shows whether a company can pay short-term liabilities without selling inventory.
$$\text{Quick Ratio} = \frac{\text{Cash} + \text{Marketable Securities} + \text{Accounts Receivable}}{\text{Current Liabilities}}$$
Putting It All Together
Solvency ratios show a company’s ability to pay back principal and interest. Liquidity ratios highlight its ability to cover current liabilities. By using both, you gain a balanced view of financial health. This helps investors, business owners, and anyone seeking to understand a company’s stability.