Key Differences Between Liquidity and Solvency

Liquidity and solvency are two key financial concepts that are often used interchangeably, but they have distinct meanings. Solvency means a company has enough money to pay its debts and stay in business over the long term. Liquidity means a company has enough cash on hand to pay its short-term bills, like salaries and rent. Let’s understand this,

Imagine you have a mortgage and a car payment. These are long-term debts. You also have a credit card bill and a utility bill. These are short-term debts. To be solvent you need to make enough money to cover all of your debts, including your mortgage and car payment. To be liquid, you need to have enough cash on hand to pay your short-term debts, like your credit card bill and utility bill.

For investors, it is important to consider both solvency and liquidity when evaluating a company. A company that is solvent but not liquid may be able to pay its long-term debts, but it may have difficulty paying its short-term bills. This could lead to financial problems down the road.

A company that is both solvent and liquid is in the best financial position. It has enough money to pay its debts and stay in business over the long term, and it has enough cash on hand to pay its short-term bills.

An asset-rich entity can encounter a liquidity problem if it does not have enough cash to meet its short-term obligations, even if it has valuable assets. Here is one story for better understanding,

An Apocryphal Story

An explorer finds a treasure trove of gold, but he is lost in the desert and dying of thirst. He comes across a water bearer who demands one unit of currency for a drink of water. The explorer has no cash, only gold. He cannot give the water bearer a gold bar because it is worth much more than one unit of currency. The explorer is in a liquidity crisis, even though he is rich.

This story shows that being rich is not the same as being liquid. Liquidity means having cash or other assets that can be easily converted into cash. Solvency means having enough assets to cover your debts. A company can be solvent but not liquid if it has a lot of assets that are difficult to sell quickly. A company can also be liquid but not solvent if it has a lot of debt that it cannot afford to repay.

It is important for a company to be both solvent and liquid. If a company is not solvent, it will go bankrupt. If a company is not liquid, it will not be able to pay its bills and will also go bankrupt.

In Summary

Liquidity and solvency are both important concepts for businesses. Companies need to be both solvent and liquid in order to survive and grow.

There are different liquidity and solvency ratios which are used to measure a company’s financial health.

Liquidity Ratios

1. Current Ratio
2. Cash Ratio
3. Quick Ratio

Solvency Ratios

1. Debt to Equity Ratio
2. Interest Coverage Ratio
3. Debt to Total Assets Ratio

Read: Decoding Interest Coverage Ratio

Following are the top 10 Liquid and Solvent companies by Market Capitalization as of November 13, 2023:

Disclaimer: This blog has been written exclusively for educational purposes. The securities mentioned are only examples and not recommendations. It is based on several secondary sources on the internet and is subject to changes. Please consult an expert before making related decisions.