Solvency Ratio vs. Liquidity Ratios – Definition – Importance – Difference

There are seemingly innumerable ways to judge the health of your business, and calculating profit margins and ROI are among the favorite methods. But there are other metrics you can utilize that are more quantitative than others.

These quantitative metrics include solvency and liquidity ratios, which can give you an insightful snapshot of your business’s current health and how well it’s poised to meet short- and long-term goals.

Definition of Solvency

Solvency refers to your business’s ability to cover its long-term financial obligations, such as bank loans, property mortgages, bonds payable, etc. If your business is solvent, you own more than you owe, and so you have a positive net worth.

Definition of Liquidity

On the other hand, liquidity refers to your ability to pay short-term obligations as well as your ability to quickly turn assets into cash. Having the ability to liquidate your assets will allow you to cover unexpected expenses while also ensuring that you stay on top of your monthly operating expenses.

Now that we know what the terms mean, let’s see how solvency and liquidity ratios can help you run your business more efficiently.

Solvency Ratios

Monitoring your solvency ratios helps you determine whether or not you’re taking on more debt than you can manage; it can also help determine if you can realistically pay off those debts in the long term. Useful solvency ratios include:

1. Debt to equity = Total debt/Total equity:

The debt to equity ratio shows how much of your business is being backed by debt or equity. Simply divide your total liabilities by your total equity. A high or rising debt-to-equity ratio could mean that you’re relying too much on high-interest loans to keep the business afloat, which is not a sustainable strategy. High dependence on loans can also make it hard for you to borrow money in the future.

2. Debt to assets = Total debt/Total assets:

The debt to assets ratio allows you to figure out how much of your business assets are financed by credits, debts and other liabilities. Divide your total debt, including current and long-term liabilities, by your total assets. A high percentage means you have a higher financial risk, since it signifies that you outright own few assets; this could hurt your chances when you are looking to borrow more capital to grow the business.

3. Interest coverage ratio = Operating income (or EBIT)/Interest expense:

The interest coverage ratio shows whether you have the financial means to pay the interest on any debts you undertake. Divide your operating income (i.e. your earnings before interest and taxes, also known as EBIT) by the money you must spend to cover expenses. The higher the ratio, the better your chances are of being able to cover the interest on any debts.

Liquidity Ratios

Liquidity ratios help you judge short-term financial health by comparing short-term assets and liabilities. Useful liquidity ratios include: 

1. Current ratio = Current assets/Current liabilities:

The current ratio tells you whether you have enough assets—including cash, inventory, accounts receivable and other collateral—to cover your current debts within a 12-month period. The higher the ratio, the more liquidity the business has. 

2. Quick ratio = (Cash and equivalents + Marketable securities + Accounts receivable)/Current liabilities:

With four things to account for, the quick ratio doesn’t read as “quick” as its name implies, but it is useful. It helps you indicate your ability to cover your short-term debts with your most liquid assets without having to sell your inventory. The higher your ratio, the more financially secure you are. A quick ratio of greater than 1.0 typically indicates that you are capable of meeting your short-term obligations.

3. Days sales outstanding = (Accounts receivable/Total credit sales) x Number of days in sales

The days sales outstanding (DSO) ratio provides a measure of the average number of days it will take you to collect revenue after you have sold a product or service to a customer. A low ratio means that it takes you fewer days to collect revenue. A high number indicates that you are selling products and services to customers on credit, which makes it longer to collect revenue. Because your capital is tied up in receivables, you have to plan and budget accordingly to cover expenses.

These ratios might take you back to your high-school math classes, but the effort you spend learning these equations will help you quickly size up the health of your business.

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