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What are the differences between solvency and liquidity?
Liquidity and solvency are two important factors to be known before making any investment. When my investments maintain liquidity or make my investment in the solvency of the company intact.
Liquidity
It is the ability of a company or firm to meet current liabilities with current assets it has. Liquidity is the short term concept and helps in paying off companies immediate liabilities.
It also measures a company's extent to meet their financial obligations, if they fall due to payment with the help of stocks, cash, securities, certificate of deposit etc. cash is a very important liquid asset and it easily turned into any other asset.
If a company's liquidity ratio is less or it can't pay off their short term obligations then it has a direct effect on their credibility and it may lead to bankruptcy (default payment continues for some time). So by knowing the liquidity position, investors can come to conclusion whether their stake is secured or not secured.
Solvency
It is the company's ability to run their operations in the long run. Solvency is the long term concept. Solvency defines whether a company can carry out their business operations or activities in the foreseeable (in future).
It also tells us that a company has more assets than its liabilities. Both assets and liabilities play an important role in a firm's financial soundness and are reflected in the firm's balance sheet.
Differences
The major differences between solvency and liquidity are as follows −
| Liquidity | Solvency |
|---|---|
| Covers immediate financial burdens. | Enough assets to meet their debts. |
| Short term obligations. | Long term obligations. |
| Tells about how quickly an asset is converted into cash. | Tells about firms' long term sustainability. |
| Ratios used to calculate are current ratio, quick ratio etc. | Ratios used to calculate are equity ratio, coverage ratio etc. |
| Low risk. | High risk. |
| Current assets, current liabilities will tell about liquidity in the balance sheet. | Shareholders equity, long-term assets etc. will tell about solvency in the balance sheet. |
| High solvency means liquidity can be achieved in a short span. | High liquidity, solvency may not be achieved. |
Conclusion
Both liquidity and solvency gives snapshots of a company's current financial health. It also gives ideas about how well they are structured in order to meet both short term and long term obligations. Monitoring both liquidity and solvency helps investors to understand whether firms can manage more debt and their payment in the long run.
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