Solvency vs liquidity. They are two economic concepts that, sometimes, are thought to be the same, which can make mistakes when making decisions. Because, do you know the differences that exist between these two terms?
Below we are going to clarify What is solvency and what is liquidity. Based on these concepts, you will see the difference and also how to calculate each of them. Shall we start?
What is solvency
We start with solvency, and the definition of this term is easy to understand. It refers to the ability of a person or a company to pay creditors. In other words, if you have the appropriate amount to be able to cover the debts that have been generated and, therefore, pay them.
If this capacity is greater than the total amount of the debt, then the person or company is said to be very solvent. On the contrary, when the ability to pay debts cannot be satisfied, then one is insolvent.
Now, many times it is thought that solvency is only at the level of cash. When in reality, to know if a company or a person is solvent, you not only have to have that money, but also the existence of checking accounts, real estate, machinery, collection rights...
What is liquidity
Once solvency is understood, would liquidity be the same? Well the truth is that no. Liquidity refers to the ability of a person's or company's assets to be converted into money.. For example, imagine that you have a business that has four warehouses. He has to pay the debt he owes to two creditors, but he has no money, so he decides to sell one of the ships to a person who was interested. The money generated from that sale is liquidity.
This example that we have given you is not usually common, because in general properties, vehicles, machines... are not susceptible to a short-term sale, and could not fall within this liquidity. But any asset that can be sold easily and quickly would be considered liquidity.
Solvency vs liquidity differences
From everything we have given you, it is clear that solvency and liquidity are two totally different things. However, on many occasions the terms are confused and it is thought that they are the same. When it's not like that.
La The main difference that exists between solvency vs liquidity is related to liquidity. This is a short-term payment capacity, while solvency is more long-term (although it also covers the short term).
It is not the only difference that exists, others that you can see have to do with assets. While Solvency takes into account a series of assets that may include vehicles, real estate...; In liquidity it is not like that, only those that are susceptible to becoming liquid in the short term.
Another difference between solvency vs liquidity has to do with risk. When a person or a company is insolvent, it means that it is not capable of meeting the debts it has (neither present nor future) and that could cause the cessation of activity or bankruptcy. For its part, the liquidity risk is lower because what is committed is more short-term solvency, that is, assets that can become liquid in the short term to pay debts or face them (because we are talking about debts of approximately 12 months).
How solvency is calculated
Now that it is clear to you what solvency is, what liquidity is and the differences between the two, do you know how solvency is calculated?
The formula to get it is the following:
Solvency = Total value of business assets / Value of liabilities
To make it easier for you to understand it. The total value of the business assets is everything that the person or company has that can be converted into money to pay debts.
For its part, the value of liabilities would be debts, what the company or person has to pay.
When the result of this formula is equal to 1,5, it is said that the solvency ratio is optimal, that is, there are no problems with the company because it is solvent. However, if the result is less than 1,5 then there are problems because you will not be able to meet your short-term debts.
If it is greater than 1,5, it will indicate that the company or person has too many assets and may be missing opportunities to invest to improve the growth of their business (or start another).
How liquidity is calculated
Like solvency, there is also a formula that calculates the liquidity ratio. This is:
Liquidity ratio = Current assets / Current liabilities
Of course, you must bear in mind that Current assets are all those assets, collection rights, treasury... in the short term. For its part, current liabilities also refer to short-term payment obligations and commitments.
The result of this formula can be, like solvency:
- Greater than one, which indicates that you have financial health. That is to say, with this short-term asset the debts that the company has at that moment can be covered.
- Less than one, which would be the worst scenario for the company because it would indicate that there are liquidity problems and it may not be able to meet all the obligations (debts) that it has to pay in less than a year.
Of course, If the formula is much greater than one, it will indicate that it has good liquidity, being able to face the debts incurred without any problem. But be careful, because having so much liquidity can be counterproductive because part of it could be invested in improving the company so that it grows.
Is the difference between solvency vs liquidity now clearer to you?