Liquidity vs Solvency

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Differences Between Liquidity vs Solvency

Before making any investment, it’s essential to know two factors upfront – whether this investment will maintain the company's liquidity and whether the investment the company is making would keep the company's solvency intact.

liquidity vs solvancy

Many investors overwhelm themselves with the meaning of liquidity and solvency; as a result, they use these terms interchangeably. However, these two are entirely different from each other.

  • Liquidity can be defined as a firm’s ability to meet the current liabilities of the current assets it has. Liquidity is a short-term concept and also one of the most important ones because, without liquidity, the firm won’t be able to pay off its immediate liabilities. We use ratios like the current ratio, quick ratio, and cash ratio to determine the liquidity of the company.
  • On the other hand, Solvency can be defined as the ability of the company to run its operations in the long run. That means solvency is a long-term concept.

And investments can affect both of these, but they are much different than each other.

Table of contents
  • Liquidity refers to a company's ability to meet its current liabilities with its current assets. This is crucial, as a company can only pay off its short-term obligations with liquidity.
  • The current, quick, and cash ratios are some ratios used to evaluate a company's liquidity. Solvency, on the other hand, is the company's ability to sustain its operations in the long term.
  • Liquidity and solvency are different concepts, with liquidity being a short-term measure and solvency being a long-term measure. 

Liquidity vs. Solvency Infographics

As you can see that each of these concepts is much different. Here are the most significant differences between Liquidity vs. Solvency described below –

Liquidity-vs-Solvency Infographics

Liquidity vs. Solvency Video Explanation

Liquidity and Solvency - Key differences

As you can already see, liquidity and solvency can’t be interchanged, and they are entirely different. Let’s look at the critical differences between Liquidity and Solvency –

  • Liquidity can be defined as a firm’s ability to pay off its current liabilities with its current assets. On the other hand, Solvency is an individual or a firm's ability to pay for the long-term debt in the long run.
  • Liquidity is a short-term concept. Solvency is a long-term concept.
  • Liquidity can be found out by using ratios like the current ratio, quick ratio, etc. Solvency can be found out by using ratios like debt to equity ratio, interest coverage ratio, etc.
  • Concept wise liquidity is a pretty low risk. Concept wise solvency is quite a high risk.
  • Liquidity needs to be understood to know how quickly a firm would be able to convert its current assets into cash. On the other hand, Solvency talks about whether the firm can perpetuate for a long period.

Liquidity and Solvency Comparison Table

The basis for Comparison between Liquidity vs. SolvencyLiquiditySolvency
1.    MeaningLiquidity can be defined as the ability of the firm to pay off its current liabilities with its current assets.Solvency can be defined as the ability of the firm is to run the operations for a long period.
2.    What it’s all about?It’s a short-term concept of having enough cash and cash equivalents to pay off the current debts.It’s a long-term concept of how well the operations of the firm would be run.
3.    ObligationsShort-term obligations (as expected)Long-term responsibility.
4.    Why understand this?To know how fast the current assets can be converted into cash.To know whether the firm can perpetuate, again and again, year after year.
5.    RiskPretty low.Quite high.
6.    What to look in the Balance SheetCurrent assets, current liabilities, and detailed account of every item beneath them;Shareholders’ equity, debt, long-term assets, etc.;
7.    Ratios used Current Ratio, acid test ratio, etc.;Debt to equity ratio, interest coverage ratio, etc.;
8.    Impact on each otherIf solvency is high, liquidity can be achieved within a short period.If liquidity is high, solvency may not be achieved quickly.

Conclusion

As you can see, liquidity and solvency are important concepts for business. But they can't be used interchangeably; because they are entirely different in their nature, scope, and purpose. Liquidity can ensure whether a firm can pay off its immediate debt. On the other hand, Solvency handles long-term debt and a firm's ability to perpetuate. Once you understand these concepts, you will be able to become prudent. You would also be able to make quick and effective decisions about the next move/s of your business.