Difference between Liquidity Ratio and Solvency Ratio

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:

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.

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