Question

Discuss that how it is possible that a company is bad in solvency but good in liquidity? Justify your Answer with example. Explain in 300 or more words.

Answer 1

Liquidity Vs Solvency

SOLVENCY :

Solvency means the ability of an entity to pay its long term debts. To be considered solvent, the value of an entity’s assets, whether in reference to an entity, must be greater than the sum of its liabilities. Various analyses can be performed to help calculate the solvency of an entity.

Certain events can create a risk to an entity’s solvency. Changes in certain regulations that directly impact a company’s ability to continue business operations can pose an additional risk.

Solvency ratios vary from industry to industry, but as a general rule of thumb, a solvency ratio of greater than 20% is considered financially healthy. The lower a company's solvency ratio, the greater the probability that the company will default on its debt obligations

Computation of Solvency ratio

Solvency ratio = (Net profit + Non cash expense)/ (ST or LT liabilities)

There are some other solvency ratios such as debt-equity ratio …etc.

LIQUIDITY:

Liquidity means to a company's ability to use its current assets to meet its current or short-term liabilities. The current ratio (also known as a working capital ratio or liquid ratio) measures the liquidity of a company and is calculated by dividing its current assets by its current liabilities. The term current refers to short-term assets or liabilities that are consumed and paid off is less than one year. Ideal Current or liquidity ratio is 2

it is possible that a company is bad in solvency but good in liquidity.

Example

In a company, ABC ltd have the following items in the balance sheet

Fixed Asset                             - 500000

Investment (LT)                      - 100000

Cash and equivalent                - 50000

Capital - 100000

LT loans and advance - 325000

ST loans                                  - 200000

Current liability                       - 25000

In the above fixed assets realizable value only at Rs. 375000.Long term loan has 5% interest. Total net profit of an entity is 50000.

Liquidity ratio:

Liquidity         = Current asset/ Current liability

                        = 50000/25000

                        = 2

In this situation ABC ltd is liquid, means current asset is more than enough for meeting current liability.

Solvency ratio = Net profit+ depreciation)/ ST and LT liability

= 50000+25000) / (325000+200000+16250)

= 0.13