7/22/2015
FinancialAnalysis:SolvencyVs.LiquidityRatios
| Free Annual Reports | Register | Sign in
DICTIONARY
Investing Basics
INVESTING
TRADING
Bonds & Fixed Income
MARKETS
PERSONAL
FINANCE
Fundamental Analysis
WEALTH
MANAGEMENT
Mutual Funds & ETFs
FINANCIAL
ADVISORS
Economics
EXAM PREP
Calculators
Symbol
TUTORIALS
SearchSearch
Search Investopedia
VIDEO
STOCK
SIMULATOR
Tutorials
Financial Analysis: Solvency Vs. Liquidity Ratios
By Investopedia Staff
AAA |
Solvency and liquidity are both terms that refer to an enterprises state of
financial health, but with some notable differences. Solvency refers to an
enterprise's capacity to meet its long-term financial commitments. Liquidity
refers to an enterprises ability to pay short-term obligations; the term also
refers to its capability to sell assets quickly to raise cash. A solvent company is
one that owns more than it owes; in other words, it has a positive net worth and
a manageable debt load. On the other hand, a company with adequate liquidity
may have enough cash available to pay its bills, but it may be heading for
financial disaster down the road.
Solvency and liquidity are equally important, and healthy companies are both
solvent and possess adequate liquidity. A number of financial ratios are used to
measure a companys liquidity and solvency, the most common of which are
discussed below.
Liquidity Ratios
Current ratio = Current assets / Current liabilities
The current ratio measures a companys ability to pay off its current liabilities
(payable within one year) with its current assets such as cash, accounts
receivable and inventories. The higher the ratio, the better the companys
liquidity position.
position.
Quick ratio = (Current assets Inventories) / Current liabilities
= (Cash and equivalents + Marketable securities + Accounts receivable) /
Current liabilities
The quick ratio measures a companys ability to meet its short-term obligations
with its most liquid assets, and therefore excludes inventories from its current
assets. It is also known as the acid-test ratio.
Days sales outstanding = (Accounts receivable / Total credit sales) x
Number of days in sales
Subscribe to our Free Newsletters!
Enter e-mail address
Sign Up
Learn More
DSO refers to the average number of days it takes a company to collect payment
http://www.investopedia.com/articles/investing/100313/financialanalysissolvencyvsliquidityratios.asp
1/7
7/22/2015
FinancialAnalysis:SolvencyVs.LiquidityRatios
after it makes a sale. A higher DSO means that a company is taking unduly long
to collect payment and is tying up capital in receivables. DSOs are generally
calculated quarterly or annually.
Marketplace
Solvency Ratios
Debt to equity = Total debt / Total equity
This ratio indicates the degree of financial leverage being used by the business
and includes both short-term and long-term debt. A rising debt-to-equity ratio
implies higher interest expenses,
expenses, and beyond a certain point it may affect a
companys credit rating, making it more expensive to raise more debt.
RELATED ARTICLES
Debt to assets = Total debt / Total assets
FUNDAMENTAL ANALYSIS
How do investors and
lenders benefit ...
Another leverage measure, this ratio measures the percentage of a companys
assets that have been financed with debt (short-term and long-term). A higher
ratio indicates a greater degree of leverage, and consequently, financial risk.
By Investopedia
FUNDAMENTAL ANALYSIS
What are the advantages and
disadvantages ...
Interest coverage ratio = Operating income (or EBIT) / Interest expense
By Investopedia
This ratio measures the companys ability to meet the interest expense on its
debt with its operating income,
income, which is equivalent to its earnings before
interest and taxes (EBIT). The higher the ratio, the better the companys ability
to cover its interest expense.
FUNDAMENTAL ANALYSIS
To what extent should you
take a company's ...
By Investopedia
Calculating Liquidity and Solvency Ratios
INVESTING BASICS
Analyze Investments Quickly
With Ratios
Lets use a couple of these liquidity and solvency ratios to demonstrate their
effectiveness in assessing a companys financial condition.
By Jonas Elmerraji
FUNDAMENTAL ANALYSIS
4 Leverage Ratios Used In
Evaluating ...
Consider two companies Liquids Inc. and Solvents Co. with the following
assets and liabilities on their balance sheets (figures in millions of dollars). We
assume that both companies operate in the same manufacturing sector, i.e.
industrial glues and solvents.
Balance Sheet (in millions
Liquids Inc.
of dollars)
Solvents Co.
Cash
$5
$1
Marketable securities
$5
$2
Accounts receivable
$10
$2
Inventories
$10
$5
Current assets (a)
$30
$10
Plant & equipment (b)
$25
$65
Intangible assets (c)
$20
$0
$75
$75
http://www.investopedia.com/articles/investing/100313/financialanalysissolvencyvsliquidityratios.asp
By Chris Dumont
Trading Center
2/7
7/22/2015
FinancialAnalysis:SolvencyVs.LiquidityRatios
Total assets (a + b + c)
Current liabilities* (d)
$10
$25
Long-term debt (e)
$50
$10
Total liabilities (d + e)
$60
$35
Shareholders equity
$15
$40
*In our example, we assume that current liabilities only consist of accounts
payable and other liabilities, with no short-term debt. Since both companies are
assumed to have only long-term debt, this is the only debt included in the
solvency ratios shown below. If they did have short-term debt (which would
show up in current liabilities), this would be added to long-term debt when
computing the solvency ratios.
Liquids Inc.
Current ratio = $30 / $10 = 3.0
Quick ratio = ($30 $10) / $10 = 2.0
Debt to equity = $50 / $15 = 3.33
Debt to assets = $50 / $75 = 0.67
Solvents Co.
Current ratio = $10 / $25 = 0.40
Quick ratio = ($10 $5) / $25 = 0.20
Debt to equity = $10 / $40 = 0.25
Debt to assets = $10 / $75 = 0.13
Scenario Analysis Comparing Ratios
We can draw a number of conclusions about the financial condition of these two
companies from these ratios.
Liquids Inc. has a high degree of liquidity. Based on its current ratio, it has $3 of
current assets for every dollar of current liabilities. Its quick ratio points to
adequate liquidity even after excluding inventories, with $2 in assets that can be
converted rapidly to cash for every dollar of current liabilities. However,
financial leverage based on its solvency ratios appears quite high. Debt exceeds
equity by more than three times, while two-thirds of assets have been financed
by debt. Note as well that close to half of non-current assets consists of
intangible assets (such as goodwill and patents). As a result, the ratio of debt to
tangible assets calculated as ($50/$55) is 0.91, which means that over 90%
of tangible assets (plant and equipment, inventories, etc.) have been financed by
http://www.investopedia.com/articles/investing/100313/financialanalysissolvencyvsliquidityratios.asp
3/7
7/22/2015
FinancialAnalysis:SolvencyVs.LiquidityRatios
borrowing. To summarize, Liquids Inc. has a comfortable liquidity position, but
it has a dangerously high degree of leverage.
Solvents Co. is in a different position. The companys current ratio of 0.4
indicates an inadequate degree of liquidity with only 40 cents of current assets
available to cover every $1 of current liabilities. The quick ratio suggests an
even more dire liquidity position, with only 20 cents of liquid assets for every
$1 of current liabilities. But financial leverage appears to be at comfortable
levels, with debt at only 25% of equity, and only 13% of assets financed by debt.
Even better, the companys asset base consists wholly of tangible assets, which
means that Solvents Co.s ratio of debt to tangible assets is about one-seventh
that of Liquids Inc. (approximately 13% vs. 91%). Overall, Solvents Co. is in a
dangerous liquidity situation, but it has a comfortable debt position.
Liquidity Crisis and Insolvency Risk
A liquidity crisis can arise even at healthy companies if circumstances arise that
make it difficult for them to meet short-term obligations such as repaying their
loans and paying their employees. The best example of such a far-reaching
liquidity catastrophe in recent memory is the global credit crunch of 2007-09.
2007-09.
Commercial paper short-term debt that is issued by large companies to
finance current assets and pay off current liabilities played a central role in
this financial crisis. A near-total freeze in the $2 trillion U.S. commercial paper
market made it exceedingly difficult for even the most solvent companies to
raise short-term funds at that time, and hastened the demise of giant
corporations such as Lehman Brothers and General Motors.
But unless the financial system is in a credit crunch, a company-specific liquidity
crisis can be resolved relatively easily with a liquidity injection, as long as the
company is solvent. This is because the company can pledge some assets if
required to raise cash to tide over the liquidity squeeze. This route may not be
available for a company that is technically insolvent, since a liquidity crisis
would exacerbate its financial situation and force it into bankruptcy.
Insolvency, however, indicates a
more serious underlying problem
that generally takes longer to work
out, and it may necessitate major
changes and radical restructuring of
a companys operations.
Management of a company faced
with insolvency will have to make
tough decisions to reduce debt, such
as closing plants, selling off assets
and laying off employees.
Going back to the earlier example, although Solvents Co. has a looming cash
crunch, its low degree of leverage gives it considerable wiggle room. One
available option is to open a secured credit line by using some of its non-current
assets as collateral, thereby giving it access to ready cash to tide over the
liquidity issue. Liquids Inc., while not facing an imminent problem, could soon
find itself hampered by its huge debt load, and it may need to take steps to
reduce debt as soon as possible.
http://www.investopedia.com/articles/investing/100313/financialanalysissolvencyvsliquidityratios.asp
4/7
7/22/2015
FinancialAnalysis:SolvencyVs.LiquidityRatios
Reading Ratios Lessons for Investors
The following points should be borne in mind when using solvency and liquidity
ratios:
Get the Complete Financial Picture: Use both sets of ratios liquidity and
solvency to get the complete picture of a companys financial health,
since making this assessment on the basis of just one set of ratios may
provide a misleading depiction of its finances.
Compare Apples to Apples: These ratios vary widely from industry to
industry, so ensure youre comparing apples to apples. A comparison of
financial ratios for two or more companies would only be meaningful if
they operate in the same industry.
Evaluate the Trend: Analyzing the trend of these ratios over time will
enable you to see if the companys position is improving or deteriorating.
Pay particular attention to negative outliers to check if they are the result
of a one-time event or indicate a worsening of the companys
fundamentals.
Conclusion
Solvency and liquidity are both equally important for a company's financial
health. A number of financial ratios are used to measure a companys liquidity
and solvency, and an investor should use both sets to get the complete picture
of a companys financial position. Additional useful information can be gleaned
by comparing a companys ratios versus its peers and by analyzing ratio trends.
TAGS:
Corporate Debt
Financial Leverage
Fundamental Analysis
License Content Order Reprints
YOU MAY ALSO LIKE
4BusinessPrinciplesLearnedGettingRichin
RealEstate
10UnusualAnimalBusinessesThatCould
MakeYouSomeMoney
http://www.investopedia.com/articles/investing/100313/financialanalysissolvencyvsliquidityratios.asp
5/7
FinancialAnalysis:SolvencyVs.LiquidityRatios
10TopPaidCEOs
FakeJobScamsYouShouldStayAwayFrom
SingleParentProgramsThat'llHelpYouBuy
YourOwnHome
The10BestU.S.CitiesforRetirement
6SecretsofLeadersWhoBuiltHugely
SuccessfulCompanies
HowToTakeMoneyOutofa401kPlan
Search Investopedia
DICTIONARY: #
CONTENT LIBRARY
Articles
Terms
CONNECT WITH INVESTOPEDIA
Videos
Free Annual Reports
Tutorials
Slideshows
Stock Simulator
FXtrader
FAQs
Calculators
Exam Prep Quizzer
Chart Advisor
Stock Analysis
Net Worth Calculator
WORK WITH INVESTOPEDIA
License Content
Symbol
SearchSearch
7/22/2015
Advertise With Us
Write For Us
Email Deployment
Contact Us
Careers
INV Sweden
http://www.investopedia.com/articles/investing/100313/financialanalysissolvencyvsliquidityratios.asp
Sign Up for Our Free Newsletters!
Subscribe
6/7
7/22/2015
FinancialAnalysis:SolvencyVs.LiquidityRatios
2015, Investopedia, LLC. All Rights Reserved Terms Of Use Privacy Policy
http://www.investopedia.com/articles/investing/100313/financialanalysissolvencyvsliquidityratios.asp
7/7
