Solvency vs. Liquidity: all the differences and importance | FNA

Are you looking to have good financial management of all your resources? Then it is key that you start to understand some fundamental concepts, such as solvency and liquidity. And although they may seem synonymous, the reality is that they have quite a few differences.

So, next, we will explain what each one consists of and why it is important to ensure them in a company.

What is solvency and how does it affect a company?

Let us begin by defining exactly what solvency is, which can be effective or technical. Simple: it is understood as the capacity of an individual to meet their payment commitments with different creditors. In other words, it is the capacity to face all their debts.

The greater the payment capacity, the more solvent it will be. Conversely, a company without the capacity to be solvent will lack sufficient assets to back its liabilities. For this reason, it becomes essential to evaluate how solvent a company is. And this can be done by verifying that there is:

• Cash
• Collection rights
• Real estate
• Machinery
• Current accounts

Knowing this, the formula to calculate how solvent a company is is very easy. You only need to divide the total value of a business's assets by the value of its liabilities. This results in the capacity to face short-term debts.

But what do the values mean? They can be:

• Equal to 1.5: this is an optimal capacity; that is, the company is solvent enough to face its commitments.
• Less than 1.5: in time, the company will have problems being solvent. Therefore, solutions will need to be sought to avoid crises.
• Greater than 1.5: the company may have too many assets and it may be advisable to dispose of them.

What are the differences between solvency and liquidity?

You may think that solvency and liquidity are the same. But no! Although both reflect the payment capacity of a company, they are different terms. Thus, the reality is that liquidity measures short-term payment capacity. By contrast, the other concept refers to long-term capacity.

Good liquidity is achieved with more current assets. By contrast, to be solvent you must have assets with financial stability. In any case, it is worth mentioning that if the company's liquidity is compromised, the company may also stop being solvent.

The main problem with the lack of liquidity is that payments are suspended, since short-term debts cannot be satisfied with liquid assets. But do not worry! It is a reversible situation, since these can be transformed into long-term debts. So they do not generate too high a risk.

How is it possible to guarantee good solvency?

Now, to ensure that the company is solvent, it is possible to follow some important tips:

Obtain additional money

The key here is to increase sales, since this will improve the economic situation. You can innovate in different products or services, and even invest in assets that generate passive earnings, without dedicating too much time to them.

Save 10% of your earnings

This is recommended to face unforeseen situations and avoid times of crisis. It can also be useful to expand your business, as it will allow you to obtain additional money, ensuring it is a solvent company.

Buy intelligently

Sometimes, companies end up not being solvent due to poor budget management. For each financial decision, perform a cost-benefit analysis and find out about other options in the market. This will allow you to only invest in what is useful to you.

Attract new partners

If you have an innovative business model or a differentiating product or service, you will be able to attract partners who contribute capital. As a result, it will be possible to pay the debt until the company improves its sales and returns to normal.

Reduce fixed costs

Finally, another tip is to lower fixed structural expenses, whether by product, service, customer or any other unit. This will allow you to improve your company's capacity to remain solvent.

In summary, you have seen that the concepts of solvency and liquidity are vital for all those organizations that want to have their accounts in order. For this reason, we invite you to take them into account, so that you know how profitable and viable your businesses are.

Bibliographic references

Ferluga, G. (2021, July 14). How to improve liquidity and solvency in times of uncertainty. El País. https://elpais.com/economia/estar-donde-estes/2021-07-14/como-mejorar-la-liquidez-y-la-solvencia-en-tiempos-de-incertidumbre.html

Gestiópolis. (2019). What is financial solvency? How is it analyzed? https://www.gestiopolis.com/que-es-solvencia-financiera-como-se-analiza/

Infoautónomos. (2021, November 9). What is the difference between solvency and liquidity. https://www.infoautonomos.com/blog/diferencia-entre-solvencia-y-liquidez/

Rankia. (2022, July 4). Problems of lack of liquidity. What are they? https://www.rankia.com/blog/bolsa-desde-cero/2722129-problemas-falta-liquidez-que-son-como-miden-interpretan

Semana. (2022, June 22). Financial system in Colombia shows good levels of solvency and liquidity. https://www.semana.com/economia/macroeconomia/articulo/sistema-financiero-en-colombia-muestra-buenos-niveles-de-solvencia-y-liquidez/202211/