What is the difference between liquidity and solvency?

Terms like liquidity and solvency are part of the finance and business jargon entrepreneurs and many others use every day. To keep up in today’s business world, you need to fully understand these concepts.

Today’s world is constantly changing, especially because of the huge amount of information people encounter every day. That creates a need to adapt by adopting and applying new concepts, ideas, and information in business and society.

What is liquidity?

Liquidity means the ability to turn an asset into cash as quickly as possible, without reducing its value in the process. It is a key indicator in the capital market, especially when evaluating any type of investment.

Depending on the level of liquidity, assets can be divided into two categories:

1. Liquid assets: cash, bank accounts, stocks, bonds, accounts receivable, and other securities;
2. Assets with a low level of liquidity: real estate, land, machinery and equipment, vehicles, works of art, jewelry, etc.

From an accounting perspective, liquidity refers to the ability of an individual or company to pay short-term financial liabilities with available assets. Short-term liabilities are financial obligations with a payment term of no more than 365 days:

1. Monthly salaries due under individual employment contracts;
2. Trade payables;
3. Financial and banking liabilities;
4. Tax liabilities.

These liabilities are recorded in a detailed register that includes all amounts due and their due dates. Based on this, liabilities and the need for financing sources to pay them are established.

What types of liquidity are there?

The liquidity of a business can be characterized by 3 types of indicators:

1. General liquidity: the ability to pay current liabilities using receivables and cash resources.
2. Current liquidity: the ability to cover mandatory current liabilities with current assets that can be turned into cash immediately;
3. Immediate liquidity: the extent to which liabilities can be paid using cash alone.

What is solvency?

Solvency is a company’s ability to carry out its operations and pay its medium- and long-term liabilities arising from previous contracts, its business activity, or taxes, fees, and fiscal contributions.

A business can be solvent if the total value of its assets (fixed assets, current assets, cash, etc.) is equal to or exceeds its total liabilities (amounts owed to suppliers, employees, etc.). Even so, the business can remain solvent even when it is temporarily unable to make payments.

Solvency is also the goal of any entrepreneur who wants to keep the business financially self-sustaining and manage it flexibly. It can be measured using the indicator called patrimonial solvency, which is calculated as the ratio between share capital and the total value of company assets.

Solvency is linked to liquidity because it comes into play when a company cannot make payments due to a lack of available cash.

What are the differences between the two concepts?

In terms of what they mean, liquidity refers to the ability to pay current liabilities using current assets, while solvency is the ability to keep a business operating over the long term. Liquidity looks at the cash and cash equivalents needed to pay current liabilities. Solvency shows whether a company can keep operating over the long term.

By type of obligation, liquidity concerns short-term liabilities, while solvency concerns long-term liabilities.

Understanding liquidity helps you evaluate how quickly assets can be turned into cash. On the other hand, solvency shows whether a company can keep operating year after year.

When it comes to liquidity, we are talking about relatively low financial risks, but with solvency, those risks reach a much higher level.

As for the relationship between solvency and liquidity, there are two situations:

1. If solvency is high, liquidity can be ensured in a short time;
2. If liquidity is high, solvency will not be achieved quickly.

What do solvency and liquidity have to do with cash flow?

Understanding liquidity and solvency plays a vital role for any business, especially during financial crises marked by a severe lack of financial resources.

Cash flow is an indicator of a company’s financial health. The inability to make payments because of a lack of cash is a reality many companies face. The risks linked to a lack of liquidity can be anticipated with a clear cash flow plan. Since liquidity helps ensure the continuity of a profitable business, and that continuity is shaped by both liquidity and solvency, cash flow becomes essential in evaluating the financial situation.

To preserve its solvency, a company must maintain a balance between collecting receivables and paying due liabilities, creating the conditions for healthy cash flow. Still, many companies fail to collect payment on issued invoices on time for the sale of products and the provision of services. Over time, this pushes the business toward being unable to pay its liabilities. That is why it has to look for financing. One solution is factoring, which lets you sell invoices due in 30, 60, 90, or even more days to a factor and get the liquidity you need to cover various expenses.

Conclusions

Liquidity and solvency are important business terms, but they differ in nature and purpose. When you understand these concepts, you’ll be better prepared to make the right decisions and support your business performance.