Question

Explain the concepts of liquidity and solvency. Why is performance on these two dimensions crucial to company survival? How does coverage analysis differ from measures of liquidity and solvency?

Answer 1

Answer:-

Concept of Liquidity:- Liquidity means the ability of a business to pay its laibilities on time. In other words, how much current assets and cash, company have to pay off its liabilities on time. It also refers to how easily an asset can be converted into cash on short notice with less discount. Companies should maintain Liquidity ratio as to aviod bankruptcy in future. The ratios that measures the liquidity of a company are known as Liquidity ratios. These include current ratio, acid test ratio, quick ratio.

Concept of Solvency:- Solvency means the ability of a business to pay its long-term debts and financial obligations. A business that is completely insolvent is unable to pay its debts and will be forced into bankruptcy. The solvency of a business is determined by solvency ratios. These are interest coverage ratio, debt to equity ratio, and the fixed asset to net worth ratio. It can be seen as the financial health of a business.

Performance of these two is very important for company's survival. If company does not have enough liquidity, then it will be very difficult for business to survive. The business should maintain liquidity ratio. Very less liquidity implies that company do not have enough cash or current assets to pay off its obligations while high liquidity implies that company is wasting its resources by neglecting the value of its assets. If company have excess cash it will be loss for company. Same in the case of solvency, if the company is unable to maintain good solvency ratios, then it will fail to pay its long term debts and financial obligations, which leads to bankruptcy. At the same time, the company should not maintain very high solvency ratios, as it leads to wastage of resources.

So, performance of these two is very crucial for company's survival.

Coverage analysis differ from measures of liquidity and solvency:- Coverage analysis measures a company's ability to pay its liabilities.Coverage ratios measure how well companies can afford to make their interest payments associated with debts. It includes dividend payments to stockholders also. Coverage ratios are times interest earned ratio, fixed charge coverage ratio, debt service coverage ratio.

The difference between them is coverage ratio analysis how well companies can afford to make their interest payments and dividend payments while liquidity and solvency ratios measures its ability to pay its short term and long term debts.