Liquidity Ratio
Liquidity ratios are one of the most important financial metrics that a company uses to determine its ability to clear its debt obligations towards creditors, without having to raise any amount of external capital. These ratios help to measure a company’s capability to manage its financial obligations. They also determine the margin for safety by calculating metrics that include accounting ratios, like the current ratio, operating cash flow ratio and quick ratio.
One of the most important aspects of the liquidity ratios is that it helps the firms to determine their capacity to convert their assets (both fixed and current) into cash in a quick and cheap manner. These liquidity ratios are extremely useful to the management, as they can be looked at and analysed in a comparative form and method. Their analysis of their organisations’ liquidity situation directs the strategic and tactical decisions. The internal analysis regarding the liquidity ratios focuses on using data from multiple accounting years using the same type of accounting method. It helps when analysts are comparing the previous accounting periods to the present operations, as it allows them to track the changes that have taken place in the business. A higher liquidity ratio is an indication that the company is more than capable of handling the immediate term debt obligations. They can also use the liquidity ratios to inform the investors and promoters about the financial position of the company.
Solvency Ratio
The solvency ratio is one of the most important accounting ratios that is used by companies to determine whether they are able to meet their long term debt obligations without any hassles. It tries to measure the firm’s actual cash flow and not just their net income. To do this, it adds back the depreciation value as well as other non-cash expenses. A solvency ratio is an indicator of whether any enterprise has sufficient cash flow reserves to ensure that they do not default on their loans and at the same time ensure that their financial position stays strong.
Solvency ratios are different from one industry to another. It is, therefore, more prudent to compare the ratio of an enterprise with its competitors from within the industry rather than seeing it in isolation. Doing so will also give an idea about the liquidity position of the company, as well as inform the influence of industry-related factors on an organisation’s ability to pay off its obligations.
Differences between Liquidity Ratio and Solvency Ratio
Although there are major areas of difference between liquidity ratio and solvency ratio, both of them are extremely important to evaluate a company’s ability to handle debt obligations. Some of the major differences between the two are as follows:
The liquidity ratio helps to measure a company’s capability to manage its short term financial obligations, and also determine the margin of safety by the calculation of several metrics that include accounting ratios like the current ratio, operating cash flow ratio and quick ratio. | The solvency ratio is one of the most important accounting ratios to determine whether a company is able to meet its long term debt obligations. It tries to measure the firm’s actual cash flow and not just their net income to assess their financial position. |
The liquidity ratio focuses on the company’s ability to clear its short term debt obligations. | The solvency ratio focuses on the company’s ability to clear its long term debt obligations. |
The liquidity ratio will help the stakeholders analyse the firm’s ability to convert their assets into cash without much hassle. | The solvency ratio will help the stakeholders analyse the firm’s ability to sustain itself in the industry over the long run. |
The ratios that help to measure the liquidity are known as liquidity ratios. Some of them are the current ratio, the acid test ratio, the operating cash flow ratio, etc. | The ratios that help ascertain the level of solvency for a business are a part of the solvency ratios. These include the interest coverage ratio, the debt to equity ratio, the fixed asset to net worth ratio, etc. |
Low liquidity can affect the creditworthiness of a business. | High insolvency for a business can also result in bankruptcy. |
Conclusion
It is clear that in spite of several points of difference between liquidity ratio and solvency ratio, both of them are accurate indicators of the financial position of a company. While one ratio focuses on the short term debt, the other lays more emphasis on the long term obligations towards the creditors of a business. The management should focus on the output from these ratios, as it can present a true picture of the liquidity and insolvency position within an organisation.
Frequently Asked Questions
Q1
What is the formula of the interest coverage ratio?
The formula for the interest coverage ratio is as follows:
Interest Coverage Ratio = Earnings before interest and taxes / Interest expenses
Q2
What is the formula of the debt to asset ratio?
The formula for the debt to asset ratio is as follows:
Debt to Asset Ratio = Debt / Assets
Q3
What is the formula of the current ratio?
The formula for the current ratio is as follows:
Current Ratio = Current Assets / Current Liabilities
Q4
What is the formula of the Quick ratio?
The formula for the Quick ratio is as follows:
Quick Ratio = Quick Assets / Current Liabilities
Q5
What is the formula of the fixed asset to net worth ratio?
The formula for the fixed asset to net worth ratio is as follows:
Fixed Asset to Net Worth Ratio = Net Fixed Assets / Net Worth
Also See:
- Change in Profit Sharing Ratio Among the Existing Partners
- Accounting Ratios
- Difference Between Current Ratio and Quick Ratio
- Difference Between Current Ratio and Liquid Ratio
- Advantages and Disadvantages of Ratio Analysis
