Q. 2
Write
a note on liquidity and solvency. Discuss the importance of liquidity and
solvency for a bank and manufacturing firm with examples. (20)
Ans
Liquidity
and solvency
We define liquidity as the firm’s ability to fulfill its
obligations in the short run, normally one year. It is the near-term solvency
of the firm, i.e. to pay its current liabilities.
It measures the extent to which the firm can meet their financial
obligations, as they fall due for payment, with the assets like stock, cash,
marketable securities, certificate of deposits, savings bonds, etc. available
to them. Cash is the highly liquid asset, as it can be easily and quickly
turned into any other asset.
When a firm is unable to pay off its short-term obligations, it
directly affects the firm’s credibility, and if the default in the payment of
debt continues, then the commercial bankruptcy occurs, due to which the chances
of sickness and dissolution will be increased. Therefore, the liquidity
position of the firm helps the investors to know whether their financial stake
is secured or not.
Solvency is defined as the firm’s potential to carry on business
activities in the foreseeable future, so as to expand and grow. It is the
measure of the company’s capability to fulfill its long-term financial
obligations when they fall due for payment.
Solvency stresses on whether assets of the company are greater
than its liabilities. Assets are the resources owned by the enterprise while
liabilities are the obligations which are owed by the company. It is the firm’s
financial soundness which can be reflected on the Balance Sheet of the firm.
Many investors overwhelm
themselves with the meaning of liquidity and solvency; as a result, they use
these terms interchangeably. However, these two are entirely different from
each other.
- Liquidity can be defined as a firm’s ability to meet the current liabilities of the current assets it has. Liquidity is a short-term concept and also one of the most important ones because without liquidity the firm won’t be able to pay off its immediate liabilities. We use ratios like current ratio, quick ratio, and cash ratio to determine the liquidity of the company.
- Solvency, on the other hand, can be defined as the ability of the company to run its operations in the long run. That means solvency is a long-term concept.
Let’s look at the key
differences between Liquidity and Solvency –
- Liquidity can be defined as a firm’s ability to pay off its current liabilities with its current assets. Solvency, on the other hand, is an individual or a firm’s ability to pay for the long-term debt in the long run.
- Liquidity is a short-term concept. Solvency is a long-term concept.
- Liquidity can be found out by using ratios like current ratio, quick ratio etc. Solvency can be found out by using ratios like debt to equity ratio, interest coverage ratio etc.
- Concept wise liquidity is a pretty low risk. Concept wise solvency is quite a high risk.
- Liquidity needs to be understood to know how quickly a firm would be able to convert its current assets into cash. Solvency, on the other hand, talks about whether the firm has the ability to perpetuate for long period of time.
Solvency and liquidity are both terms that refer to an
enterprise's state of financial
health, but with some
notable differences. Solvency refers to an enterprise's capacity to meet its
long-term financial commitments. Liquidity refers to an enterprise's ability to pay short-term obligations; the term also refers to a company's capability
to sell assets quickly to raise cash. A solvent company is one that owns more than it
owes; in other words, it has a positive net worth and a manageable debt load. On the other hand, a company with adequate
liquidity may have enough cash available to pay its bills, but it may be
heading for financial disaster down the road.
These are the two parameter which decides whether the investment
will be beneficial or not. This is because these are related measures and helps
the investors to carefully examine the financial health and position of the
company.
For a layman, liquidity and solvency are one and the same, but
there exists a fine line of difference between these two. So, take a glance at
the article provided to you, to have a clear understanding of the two.
Importance of
liquidity and solvency for a bank and manufacturing firm with examples.
Calculating Liquidity and Solvency
Ratios Liquids Inc & Solvents Co
Let's use a couple of these liquidity and solvency ratios to
demonstrate their effectiveness in assessing a company's financial condition.
Consider two companies – Liquids Inc. and Solvents Co. – with the
following assets and liabilities on their balance sheets (figures
in millions of dollars). We assume that both companies operate in the same
manufacturing sector, i.e. industrial glues and solvents.
|
Balance Sheet (in millions of dollars)
|
Liquids Inc.
|
Solvents Co.
|
|
Cash
|
$5
|
$1
|
|
Marketable securities
|
$5
|
$2
|
|
Accounts receivable
|
$10
|
$2
|
|
Inventories
|
$10
|
$5
|
|
Current assets (a)
|
$30
|
$10
|
|
Plant & equipment (b)
|
$25
|
$65
|
|
Intangible assets (c)
|
$20
|
$0
|
|
Total assets (a + b + c)
|
$75
|
$75
|
|
Current liabilities* (d)
|
$10
|
$25
|
|
Long-term
debt (e)
|
$50
|
$10
|
|
Total
liabilities (d
+ e)
|
$60
|
$35
|
|
Shareholders' equity
|
$15
|
$40
|
In our example we
assume that "current liabilities" only consist of accounts payable and
other liabilities, with no short-term debt. Since both companies are assumed to
have only long-term debt, this is the only debt included in the solvency ratios
shown below. If they did have short-term debt (which would show up in current
liabilities), this would be added to long-term debt when computing the solvency
ratios
Liquids Inc.
Current ratio = $30 / $10 = 3.0
Quick ratio = ($30 – $10) / $10 = 2.0
Debt to equity = $50 / $15 = 3.33
Debt to assets = $50 / $75 = 0.67
Solvents Co.
Current ratio = $10 / $25 = 0.40
Quick ratio = ($10 – $5) / $25 = 0.20
Debt to equity = $10 / $40 = 0.25
Debt to assets = $10 / $75 = 0.13
National Bank of Pakistan liquidity
and solvency
Solvency 2004 2005 2006 2007 2008 ---------------------------------------------------------------- Equity to Assets
7.22% 10.79% 13.01% 13.85% 12.60%
Equity to Deposits
8.57% 13.14% 16.34% 18.13% 17.98%
Earning Assets to Deposits
0.86 0.89 0.95 0.96 0.96
Liquidity
2004 2005 2006 2007 2008
----------------------------------------------------------------
Earning Assets to Assets
0.72 0.73 0.76 0.75 0.74
Advance to Deposit
0.44 0.53 0.61 0.60 0.62
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