As it is rightly said that “Sometimes it’s not about the money, but rather the process of managing the money”
More often than not most of us confuse between Liquidity and Solvency. But actually both are significantly different from each other.
Liquidity refers to the ability of the business to meet its present existing, short-term obligation. It requires business to have enough cash and cash equivalents in hand. Italso states whether a business is able to meet its current liabilities with its existing current assets.
Whereas, Solvency refers to the ability of business to continue its operations and grow in long-term. It requires a business to have solid equity base to meet its liabilities and obligations in the long run.It’s a measure of whether a business will be able to perpetrate year after year.
Let’s take an example:
1. Business has equity and reserves of INR 1000 Crores, debt of INR 300 Crores, cash & cash equivalents worth INR 80 crores,current payables are INR 100 crores and operating profit of INR 20 Crores.
On the basis of above facts the business does not have a sound liquidity ratio for which the business might have to face challenges in its day to day operations, whereas the company has good solvency ratio which might help the company to overcome its liquidity issues if managed appropriately.
2. Business has equity and reserves of INR 100 Crores, debt of INR 400 Crores, cash & cash equivalents worth INR 150 crores, current payables are INR 80 crores and operating profit of INR 20 Crores.
On the basis of above facts the company has reasonably good liquidity ratio, whereas the solvency ratio is high which might affect the businesses going concern mechanism.
Study of Liquidity is important to understand how quickly can one’s current assets be converted into Cash, whereas solvency explain about the long term wealth generation prospects of the organization.
Liquidity of a business can be found out using Liquid Ratios, such as:
- Current ratio- Where the total of Current assets are divided by total of Current Liabilities to measure the sufficiency of current assets for repaymentof the current liabilities of the business,
- Quick Ratio – Where Stock/inventory and prepaid expenses are excluded from the total of current assets to find out readily available/ realizable Current Assets which could be used to set-off/re-pay the current liabilities.
The ideal current ratio is considered to be 2:1, which means that ideally there should be twice of currentassets as there are current liabilities. If the current assets are more than twice of current liabilities, there might be possibility of the business facing difficulty in realizing its debtors, long outstanding inventorypiled up for near approaching expiry or the available cash is not being managed properly.
In the recent days, many NBFC companies could not perform due to lack of liquidity management, despite of having good balance sheet.
On the other hand Solvency of a business can be measured by using Solvency ratios, such as debt to equity ratio- Where the total debt of the business is divided by the equity to measure the company’s ability to repay its debt obligation. The ideal debt equity ratio is considered around 1 to 1.5. However this might also vary depending upon the industry as certain industries prefer debt as better financing opportunity.
As one of the primary financial objective of any business is to minimize its cost of capital, the organization can employ debt in its capital structure till the proportion it minimizes its cost of capital. But at the same time, excess of debt can make the business to be lot more risky and it will eventually lead to increase the cost of capital of the business.
In general, both the terms are inter-dependent on each other, as a solvent business has good creditability, and at the same time liquidity can in-turn improve the operating effectiveness of the business which will have a positive impact on its solvency. On the other hand, a consistent series of liquidity crisis will eventually turn out to be solvency crisis over a period.
But this always doesn’t go the same way, as even the well-established solvent businesses may also have to face temporary liquidity crunch due to changes in external economic conditions or due to introduction of new industry specific policies by the government.
Risk of solvency is greater than the risk of liquidity, as the solvent businesses can fight their liquidity issues by adopting adequate financial, operational policies; but if the business lacks solvency, it is difficult for the organization to survive.
Government Intervention:
In case of liquidity crises due to various economic, political or regulatory factors, the government with the help of central bank can infuse liquidity in the markets through lowering the interest rates and making credits easily available to help businesses revive.
At times, government also grants loans to specific industries which are facing liquidity crises. It can also arrange for a special window to grant quick loans to specific industries to help them revive, survive and grow.
However, the government’s intervention to help the businesses with their solvency issues might be minimal as it depends upon the businesses, what kind of strategies they adopt to find a long way out forresolving their solvency issues.
Conclusion:
To make an informed and prudent business decision, an investor needs to monitor both the solvency and liquidity prospects of the business. In other words, Liquidity can ensure regular dividend payouts, whereas solvency can ensure capital appreciation in the investments made.
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