Liquidity vs Solvency: Short-Term Stability vs Long-Term Survival

In finance and economics, two important terms—Liquidity and Solvency—are frequently asked in competitive exams. Both terms measure the financial health of a company, but they do so in different ways. Liquidity tells how quickly a company can meet short-term needs, while solvency shows whether it can survive in the long run.

What is Liquidity?

Liquidity refers to a company’s ability to meet its short-term obligations using its most easily available assets like cash, bank deposits, and inventory.

It checks whether the company can pay its bills within one year.

Key Points

• Measures short-term financial strength
• Focuses on assets that can be quickly converted into cash
• Shows immediate financial stability

Examples of Liquid Assets

• Cash
• Bank balance
• Marketable securities
• Inventory
• Accounts receivable

Simple Example

A company must pay ₹50,000 to suppliers within a week.
If it has ₹70,000 cash in hand, it has good liquidity.

What is Solvency?

Solvency refers to a company’s ability to meet long-term obligations, such as long-term loans, bonds, or financial commitments extending for several years. It shows whether the company can survive in the long run.

Key Points

• Measures long-term financial strength
• Focuses on total assets vs. total liabilities
• Determines business stability and survival

Examples of Long-term Liabilities

• Bank loans (over 1 year)
• Bonds
• Debentures
• Mortgage loans

Simple Example

If a company owns assets worth ₹1 crore and has total long-term debt of ₹40 lakh, it is solvent.

Liquidity vs Solvency: Key Differences

1. Time Frame

• Liquidity: Short-term (less than 1 year)
• Solvency: Long-term (more than 1 year)

2. Focus

• Liquidity: Cash availability
• Solvency: Total financial strength

3. Purpose

• Liquidity: Can the company pay immediate bills?
• Solvency: Can the company survive for years?

4. Related Ratios

• Liquidity Ratios: Current Ratio, Quick Ratio
• Solvency Ratios: Debt-to-Equity Ratio, Interest Coverage Ratio

5. Interpretation

• A liquid company may not always be solvent.
• A solvent company may temporarily face liquidity issues.

Important Ratios for Exams

1. Current Ratio (Liquidity)

• Current Ratio = Current Assets ÷ Current Liabilities
• A ratio above 1 shows good liquidity.

2. Quick Ratio (Liquidity)

• Quick Ratio = (Current Assets – Inventory) ÷ Current Liabilities
• Shows whether a company can pay bills without selling inventory.

3. Debt-to-Equity Ratio (Solvency)

• Debt-to-Equity Ratio = Total Debt ÷ Shareholder’s Equity
• Lower ratio = better solvency.

4. Interest Coverage Ratio (Solvency)

• Interest Coverage = EBIT ÷ Interest Payments
• Shows how easily a company can pay interest on loans.

Summary Table