Financial management of a business can be daunting, especially when the business is scaling and owners need to balance learning financial concepts and applying them to their day-to-day management activities. Solvency, liquidity, and cash flow are important aspects of not only mitigating the risk of failure but also effectively balancing debt.
Understanding these concepts is important because they’re often used to measure your company’s financial health by bankers, investors, shareholders and lenders. If you want to maintain a business that can raise or borrow money, the better your liquidity and solvency are, the easier it is to raise or borrow capital.
Liquidity vs. Solvency: The Primary Differences
Let’s start with the basics. What do these two terms mean in a nutshell?
Solvency is a company’s ability to meet its long-term debt obligations. Long-term debt is defined as any financing or borrowed monies that will be paid back after 12 months.
Liquidity is a company’s ability to meet its short-term debt obligations. Short-term debt is defined as any debt that will be paid back within 12 months.
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As a note, one important characteristic of short-term vs long-term debt is that a single loan could be considered both. For example, if you have a loan that you are paying back over a two-year period, the first year of payments due is considered short-term debt, while the second year of payments is considered long-term debt.
It all has to do with timing of repayment—not the type of debt. Many companies report this on their financial statements, and they’ll appear on the balance sheet in this fashion.
In summary, the company’s ability to pay off its debts in the short-term and long-term is the concept behind liquidity and solvency. So how can business owners use these concepts to make decisions about their businesses?
Liquidity and solvency can help business owners answer the following questions:
- Do I have enough revenue being generated in the coming months to pay off my debts if I needed to?
- How much profit or cash flow would I need to set aside to pay off these debts?
- How much debt could I take on and still have the ability to pay off?
The phrase “spend money to make money” may be overused, but it rings true for many business owners. Unless you’re able to finance business growth solely through profits, your business will likely need to turn to other financing options along the way, like credit cards or traditional bank loans.
Whenever someone is lending you money, they’ll want reassurance that their money will eventually be repaid in full (and then some). Measuring solvency and liquidity allows them to gauge
Measuring Liquidity & Solvency
When outside parties are evaluating whether or not to lend you some money, what do they look at specifically? In other words, what are the metrics they use to evaluate your worthiness of their money?
There are several metrics and financial ratios that banks and lenders can use to evaluate your liquidity and solvency using your financial statements as a starting point. Your balance sheet, in particular, will play an important role.
As a business owner, you’ll want to keep an eye on these metrics regularly so that you can monitor changes over time and—as we’ll discuss later—make adjustments to intentionally.
Balance Sheet vs. Income Statement
When calculating both liquidity and solvency, the balance sheet will be the primary location you’ll go to pull important information. However, when it comes to measuring solvency, you’ll also need to access your income statement.
The balance sheet is a snapshot of your business—what it owns and what it owes to other people—at a particular moment in time. The income statement, on the other hand, shows how much money you brought in and spent over a period of time. As you think about the key differences between liquidity and solvency, knowing the fundamental differences between these two reports will help you navigate these metrics.
How to Measure Liquidity
Unlike solvency, liquidity is a short-term concept. It deals with a company’s ability to meet its short-term obligations, or those debts that will need to be paid within the next twelve months.
To liquidate your assets simply means to sell them off and convert them into cash, which can then be used to pay off debts. So liquidity is simply a measure of how easily you can do that for debts that will become due within the next year.
There are a few liquidity ratios that can be helpful in evaluating how liquid your company is.
First up, the current ratio shows whether or not your current assets outweigh your current liabilities. In other words, do you have enough cash or other liquid assets to pay off all current debt?
To find out, simply divide current assets by current liabilities, both of which can be found on your balance sheet.
Current Ratio = Current Assets / Current Liabilities
A current ratio under 1 means that you do not have enough to pay for what you owe—right now. Ideally, a company should have a ratio between 1.5 and 3. It is important to understand that this metric changes quickly because it includes short-term debt, meaning that a new bill or a new sale can cause it to swing in one direction or another.
To make it easy, we’ve created a free current ratio calculator.
Quick Ratio (Acid-Test Ratio)
The quick ratio, also referred to as “acid-test” ratio, resembles the current ratio closely. The main difference? The quick ratio excludes inventory from the equation.
Inventory is technically considered a current asset. However, unlike your accounts receivable, it’s unclear when your business can expect that inventory to be sold and converted into cash. You could sell through all of that inventory in a few months, or it could sit on warehouse shelves for a few years. While marketing initiatives might impact when it’s sold, there are no guarantees.
So the quick ratio ignores it and shows how a business might cover short-term liabilities with all current assets except inventory. Here’s the formula for the quick ratio.
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
If inventory makes up the bulk of your current assets, the quick ratio may be a more helpful financial metric for you to keep track of.
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How to Measure Solvency
As a reminder, solvency is a measure of your business’ ability to meet its long-term obligations. Ratios that measure solvency, therefore, help you understand your overall performance better than liquidity ratios do because liquidity can change more rapidly.
The phrase “staying solvent” simply means that you’re able to pay all debts. Like liquidity, there are several financial ratios that can help you analyze your business’ overall solvency.
One of the most common formulas used to calculate a company’s ability to pay off both long-term and short-term debt is referred to as the solvency ratio, which can be calculated using the following formula.
Solvency Ratio = (Net Income + Depreciation) / (Short-Term + Long-Term Liabilities)
The solvency ratio looks at after-tax income and adds back non-cash items like depreciation and amortization before dividing by liabilities. The reason depreciation and amortization are not factored in is to give a business a more accurate view of their cash flow and how they’ll be able to pay off liabilities (without taking the more conceptual elements of accounting into account).
Net income and depreciation can be found on your income statement, while short- and long-term liabilities are found on the balance sheet. For a full breakdown of your financial statements, check out our financial statements cheat sheets here.
The solvency ratio is a good measure of a company’s ability to meet its overall debt obligations, or liabilities, and is a fairly common ratio used by lenders and investors. The difficulty in applying this ratio is that you need to understand what’s “normal” for your industry. Industry-accepted solvency ratios can vary a bit, so do some homework and speak to others in your industry to get a feel for what’s acceptable for your business.
While the solvency ratio is the primary means of evaluating solvency overall, there are other financial ratios that can help round out the picture of a company’s long-term health. One such metric is the debt ratio, which compares total assets to total debt.
Debt Ratio = Total Debt / Total Assets
Businesses with a high debt ratio, usually greater than 1, are considered highly “leveraged,” or at a higher risk of being unable to pay off their financial obligations. In contrast, a low debt ratio implies that a larger portion of a company’s assets are funded by equity, rather than debt.
Like the solvency ratio, what’s considered an acceptable debt ratio can vary widely, so it’s important to understand the expectations of your industry.
The debt-to-asset ratio is similar to the debt ratio, but looks at total liabilities, instead of total debt. Debt and liability are often confused, but the terms don’t mean exactly the same thing. Debt refers specifically to money that’s borrowed, while liabilities can include other types of financial obligations.
An easy way to keep it straight? All debts are liabilities; not all liabilities are debt.
With that in mind, here’s the formula for the debt-to-asset ratio.
Debt-to-Asset Ratio = Total Liabilities / Total Assets
The same general rules apply for debt-to-asset ratio analysis. Anything greater than one may signal that your company is too leveraged, but it’s important to keep industry expectations in mind.
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How Liquidity and Solvency Interact With Cash Flow
You’ve measured your company’s liquidity and solvency, and you don’t like what you see. So what’s next?
Adjusting what you do with cash flow by either paying off debts or adding to them can control how both liquidity and solvency appear and are perceived by bankers, investors, shareholders, and lenders.
If your company’s solvency ratios are too high, you might consider focusing your efforts over the next few months on paying down your debts. Extra cash flow from a strong month of sales could be put toward debt instead of investing that money into something new.
Likewise, if you have extremely low solvency ratios, now could be the time to explore financing the growth you’ve been thinking about. While low ratios are often desired, consistently low numbers may signal to interested parties that you’re not willing to invest in new initiatives.
Like all metrics you measure to analyze your small business, no metric should be the be-all and end-all of financial decision making. It’s important to check in on several metrics at a regular cadence. That said, if investors or loans are in your business’ future, it’s good practice to start looking at liquidity and solvency metrics with a more discerning eye.
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