Question

Summarize the issues one should address in the analysis of: Short term liquidity and Long-term solvency

Please discuss the issues, not definitions. Thank you

Answer 1

Solvency and Liquidity both the measure the ability of an entity to pay its debts. While solvency focuses on long term , solvency is concerned with short term payments.

Solvency refers to ability of a business to pay its liablities on time. solvency measures whether the business can generate sufficient cash flow to operate over the longer term say more than 5-10 years.

Issues in solvency

First issue is of the risk in late payments means delays in paying liabilities on time can cause serious problems for a business For example customers and suppliers may shy away from doing business with a company that have serious financial problems. Also, Vendors may be not be willing to sell the company products because of risk of not being paid. Customers, suppliers and vendors may hear about company financial issues through print and electronic media like Newspaper and Tv news for example if there is a news of family dispute in the business it is very much possible that might lead to hampering the business and in turn affect business position to pay liablities on time as owners are fightning over ownership of the business.

Another issue faced in long term solvency is voluntary and involuntary bankruptcy. when owners of more than 51% shares feels that liabilities are too much and assests are just not there to pay off liabilities on time they may go for voluntary bankruptcy. In involuntary bankruptcy, a court appointed trustee may take substantial control over the business and has the power to decide about debt payment decisions. Even threat of involuntary or voluntary bankruptcy can cause serious disruptions in normal operations of the business as none like employees, suppliers, vendors and customers see any value in dealing with a business that is under insolvency threats.

On the other hand Liquidity refers to the ability of a business to keep its cash balance and cash flows at adequate levels so that operations are not disrupted by cash shortfalls. When considering liquiduty the focus is genrally short term say 6 months to 1 year maximum.

Issues in Short term liquidity

Payment to suppliers is one such issue when a business buys goods from suppliers on credit then suppliers provide a usual credit period of say 30 to 90 days with cash discounts for early payments as well .For example supplier may say pay me without any discount in 90 days the standard credit period or pay me in 10 days and avail 2 % cash discount. Now the business has to decide whether to borrow and pay the supplier in 10 days and avail 2% cash discount or pay supplier only after 90 days. Note that if they pay within 10 days it might affect short term liquidity of the business as it is very much possible that debtors payment cycle is 30 days so paying supplier in 10 days is risky as it affects cash balance in an adverse way.

Another issue with short term liquidity is that of the working capital management. Working capital refers to current or short term assests minus current liabilities. Efficiient management of working capital does not create any problems for short term liquidty but if working capital is not managed properly then it might lead to borrowing of loans to manage working capital resulting in increase in long term liablities and affceting the solvency of the business in the longer run. For example business need to pay to supplier in 30 days a payment of $100,000. Also Business needs to collect payments from debtors in 20 days but debtors could not pay within 20 days and demanded 90 days to pay as they are facing problems and a few debtors have gone bad resulting in bad debts so in this case company might need to borrow working capital loans and in some cases where payments to suppliers is of large amount company needs to borrow long term loans as well which affect both short term liquidity as well as long term solvency of the business.