Solvency Ratio vs Liquidity Ratio
Most professional investors who have been investing for a long period can identify undervalued stock with the capacity to appreciate at a price in the short or long term. They believe that if you invest based on extensive company analysis, the chances of losses and overall risk decrease. Once the stock reaches its true value, the investors earn huge profits. However, identifying such stocks is tough, which is made easy by various investing tools professional investors use to make profitable investment decisions. Two of such widely used investments tools are Liquidity Ratio and Solvency Ratio.
Liquidity vs Solvency: What’s the difference between the two ratios?
Liquidity vs solvency is one of the most important factors used by investors to analyse a company and its prospects.
Liquidity Ratio is defined as the ability of a company to repay the debt it borrowed for the short term and convert its assets to cash. The idea behind analysing a company liquidity ratio is that a company is taken as financially strong if it can convert its short term assets to cash to pay off its short term debts. Furthermore, if a company has a healthy liquidity ratio, the company can buy additional assets to improve its profitability. For a company to be worthy of investment, the higher the liquidity ratio, the more liquid the company will be and would have better coverage of outstanding debts.
The solvency ratio of a company measures a company’s actual cash flow to provide a comprehensive idea about the company’s ability to repay its long-term debt and meet its other financial obligations. The idea behind analysing a company's solvency ratio is to assess the company’s capacity to stay afloat and not go bankrupt because of crumbling revenue and profits. If a company’s solvency ratio is healthy, it means that the company can repay its long-term debt along with the interest payments. The higher the solvency ratio, the better the company’s long term financial prospects.
How do you access solvency?
Solvency is a company’s ability to repay its long-term debt. As every company borrows to run its operations, it must use the borrowed money to earn profits, using which it can repay the debt and interest. If a company defaults on such financial obligations, it means that the company is financially struggling.
However, a solvent business has a positive net worth and cash flow, which that its total assets are higher than its total liability. In the case of assessing a company’s solvency, investors use solvency ratios. If the solvency ratio is higher, it becomes more probable for the company to be afloat and financially healthy in the long term.
What is Solvency Risk?
Solvency risk is defined as a company’s inability to meet its financial obligations. The value of debt exceeds the total value of the assets of the company, meaning that it won’t be able to pay off debt even after it sells all the assets of the company. This solvency risk of being completely insolvent leads a company to bankruptcy. Solvency risk can be assessed by analysing the company's solvency ratio.
Liquidity ratio allows an investor to understand how liquid a company is for converting short-term assets into cash. On the other hand, the solvency ratio relates to a company's long-term financial health and how it can grow its profitability in the future to meet its financial obligations. When analysed together, liquidity and solvency ratios allow investors to identify stocks that are undervalued and can increase in price in the future. Hence, it is always better to look at the liquidity and solvency ratios alongside and then make informed investment decisions
Frequently Asked Questions Expand All
A company's liquidity relates to its ability to pay off short-term debts by converting its short-term assets to cash. It means that a company will be financially afloat in the short term. On the other hand, a company's solvency relates to its ability to pay off long-term debt and meet other long-term financial obligations. If the company is solvent, it means that the total value of its assets is higher than the total value of liabilities.
There is no difference between the solvency ratio and leverage ratio. They are used interchangeably to assess the solvency of a specific company.
Although acceptable solvency ratios may differ from industry to industry, a good solvency ratio of up to 20% or 30% is considered ideal.