TOPICS: Liquidity and solvency
Liquidity and solvency are two of the most important parameters of a financial organisation. But it is usually solvency that mainly concerns stakeholders.
It’s equally true that liquidity is cyanide while solvency is liver cirrhosis. Lack of liquidity kills you very fast whereas in insolvency you get enough time to improve. And it’s equally true that liquidity directly affects the profitability and in the long run solvency of an organisation.
The above lines summarise how difficult it is for an organisation to strike a balance between liquidity and profitability to sustain a better solvency position. Liquidity of an organisation is usually measured by availability of cash balances and other assets that can easily be converted into cash with only a little or no impact in its value.
These liquid assets provide comparatively less return and also have lower risk. The other assets are money market instruments, government bonds etc. We can say liquidity is the ability of an organisation to settle its short term obligations for continuous operation. It’s also essential for an organisation to maintain a balance between liquidity and profitability.
Some organisations are profitable financially but due to lack of liquidity they fall in the liquidity maze trap which may eventually lead to the insolvency of that organisation. An organisation is said to be in a liquidity maze trap if it cannot convert its assets into liquid assets to be used for operation.
Solvency of an organisation is indicated in the balance sheet and is the difference between assets and liabilities. But the most accurate financial definition would be the ability of an organisation to honour its long term obligations. A solvent company will have positive net worth and that’s what we as stakeholders are mainly concerned about.
Solvency is measured by solvency ratios which include debt to equity ratio, net worth etc. To maintain solvency an organisation must be able to generate sufficient profits over a period so it may be that in the initial stages of business the net worth may be negative, but we have to consider the net worth after a period of effective operation.
Solvency and liquidity are so closely inter-related that liquidity is also called short term solvency. Also an organisation can tackle liquidity problems properly only if it has sufficient solvency margin.
So liquidity is deterministic for short term stability whereas solvency is the key factor for long term sustainable development.