In the financial analysis of a business, solvency can refer to how much liquidity the business has. When referencing a company's ability to pay debts, liquidity and solvency often differ in that liquidity refers to the ability to meet short-term obligations and solvency refers to the ability to meet long-term obligations. Financial analysis of a business makes use of liquidity ratios to measure solvency to predict the company's capacity to service debt, both now and in the future.
Understanding the Concepts
Liquidity is synonymous with financial resources, convertible assets and cash flow in a company. Solvency is synonymous with overall creditworthiness. The terms may be used interchangeably when referring to the internal liquidity of a company. For example, if a business has sufficient liquidity --- that is, current assets to meet short-term debt obligations --- an analyst may remark that the company has solvency, or is solvent.
Ratios and Measurements
Analysts calculate different ratios to evaluate a company's liquidity and consequent financial stability. The most commonly used liquidity formula is called the "current ratio." This ratio is based on the premise that current assets will be liquidated, i.e., converted into cash, within the year and therefore be available to meet short-term obligations. Current ratio equals current assets divided by current liabilities. A broad measure of a company's overall solvency is net working capital, which equals current assets minus current liabilities.
Investors pay attention to the findings and opinions of financial analysts who have reviewed the books of public companies and make investment decisions based on the liquidity and solvency of the business. The ability to meet debt obligations is paramount to a company in paying interest to bondholders and dividends to stockholders. In another use of liquidity data, state and federal insurance industry regulators consistently monitor the solvency of insurers to assure that they maintain sufficient liquid assets to meet the needs and demands of policyholders.
A company that does not appear to have sufficient solvency to meet debt obligations may be headed for failure. However, this is not always the case. For example, a rapidly expanding company may have very little working capital to meet current short-term obligations, but may still continually make record profits. In addition, in some business industries stockpiling a large amount of working capital is simply not necessary if the company has a rapid turnover of products and collects immediately on receivables. Comparing the internal liquidity or solvency of a company to that of its competitors and similar businesses within the same industry helps put the data into perspective.
- "Finance: Investments, Institutions, Management"; Stanley G. Eakins; 2005
- "Investment Analysis and Portfolio Management"; Frank K. Reilly, et al.; 1997
- National Association of Insurance Commissioners; The United States Insurance Financial Solvency Framework; 2010
- Principles of Accounting: Chapter 4 --- The Reporting Cycle
- Principles of Accounting: Chapter 16 --- Financial Analysis and the Statement of Cash Flows
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