Some people may be confused by the terms “solvency” and “liquidity” as they thought that these terms bring the same meaning. Solvency refers to the ability of a company in maintaining its long-term operation. On the contrary, liquidity is the effectiveness of a company in covering its current liabilities by using its current assets (Also see An Overview of Quick Assets). These two aspects are what the investors will prioritise when they are deciding whether they should invest in a company.
Identifying the solvency and liquidity of a company requires clear and accurate financial information that the company has presented on its financial statement. Hence, business owners need to make sure that they have prepared their financial statements correctly for those statements to present the company’s financial position (Also see Limitations of Financial Statements). They should not neglect the bookkeeping and accounting processes in their daily operations, and they may hire an accounting firm in Johor Bahru if they need help in keeping their books of accounts.
Solvency is the potential that a company has in the near future for its expansion and growth. It measures the company’s ability in meeting its long-term financial obligations if its bills or loans have become due for payment. Solvency emphasises on whether the company’s asset has a greater value compared to its liabilities. This is a company’s financial robustness, and business owners get to know this from the company’s balance sheet.
People often use solvency to measure the financial health of a company in the long run. Solvency has a close relationship with the capability of a person or a company in paying their long-term debts as well as any associated interest. Lack of solvency may lead to liquidation as this may bring an impact on the company’s daily operations, and this will affect its revenue.
Liquidity refers to the ability of a company to fulfil its short-term obligation, usually in a year. This is the company’s short-term solvency, and it is a measure of the extent that the company can fulfil its financial obligations when it falls due for payments. The assets that a company can use to pay for the financial obligations are cash, saving bonds, stock and others. Cash is a highly liquid asset because the company can turn it into any other assets quickly and easily.
If a company is not able to pay its short-term obligations, its credibility will be directly affected. If the failure to fulfil the financial obligation continues, the company will have an increased chance of sickness and dissolution, and this may lead to commercial bankruptcy. Therefore, investors may determine whether the financial stake is secured by looking at the company’s liquidity position.
Investors will be able to know whether a company can cover its financial obligations by knowing its solvency and liquidity. They may make use of the liquidity and solvency ratios to achieve this purpose. Usually, the banks, creditors and suppliers will also use these ratios when performing credit analysis on a company.