Question

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Discuss what it is for a business to liquid. How do you measure liquidity? Discuss what it is for a business to be solvent. How do you measure solvency?

Answer 1

Measuring Solvency and Liquidity to Assess Business Strength

A businesses liquidity and solvency indicate its financial well-being, which ultimately measures that businesses strength and sustainability.

All companies are required to calculate their liquidity and solvency from time to time, but especially when declaring a dividend, if a loan is given to a director, shareholder or an interrelated entity, or in the case of a merger. The Financial Advisory and Intermediary Services Act also requires that all organisations, except those registered as a category IV with the Financial Services Board, conduct an annual assessment of its liquidity and solvency.

It is also good business practice for the owners, shareholders, directors or management of an organisation to look at a company’s liquidity, cash flow and current ratios from time to time to determine the ‘general well-being’ of the entity. It is possibly the first and most essential assessment required for making some business decisions – such as whether or not to expand an enterprise, whether to invest excess funds, and if funds are needed from external sources.

What is solvency versus liquidity?

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-termfinancial commitments. Liquidity refers to an enterprise’s ability to pay short-term obligations; the term also refers to its 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. Solvency and liquidity are equally important, and healthy companies are both solvent and possess adequate liquidity.”

Calculating Liquidity

The liquidity ratio of a company measures its ability to pay its short-term debts. There are three common calculations for liquidity ratios - the current ratio, the acid ratio, and the cash ratio.

The current ratio indicates a company's ability to pay its current liabilities from its current assets. This is often used to quickly measure the liquidity of a company.

This formula considers all current assets and current liabilities. Current assets are those assets that are expected to turn into cash within one year or within the normal operating cycle of the entity. “Examples of current assets are cash, accounts receivable, and prepaid expenses. Current liabilities are those debts that are expected to be paid or come due within a year or in the normal operating cycle of the entity– such as accounts payable and payroll liabilities.”

The second ratio is the acid ratio. “The purpose of this ratio is to measure how well a company can meet its short-term obligations with its most liquid assets - those that can be quickly turned into cash.”

The final ratio is the cash ratio, which is an indicator of a company's liquidity that further refines both the current ratio and the quick ratio by measuring the amount of cash, cash equivalents or invested funds there are in current assets to cover current liabilities.

How these ratios are applied

These three ratios are often grouped together by financial analysts when attempting to accurately measure the liquidity of a company but that the nature of a business will affect the ratio employed.“For example if an entity has inventory that may need time to mature, or undergo a long process to be available for sale – such as a distillery or wine farm - in which case the acid test ratio would be applied.”

A company’s ability to pay its debt and grow reserve cash funds is vital to an entity’s ability to survive in these economic times. The calculations above can assist owners, shareholders, directors or management to work better towards the goals of the entity and avoid making decisions that could cost the company in the long run.

Calculating Solvency

“A key metric used to measure an enterprise’s ability to meet its debt and other obligations is the Solvency Ratio which indicates whether a company’s cash flow is sufficient to meet its short-term and long-term liabilities. The lower a company's solvency ratio, the greater the probability that it will default on its debt obligations.

“The solvency ratio is a comprehensive measure of solvency, as it measures cash flow – rather than net income – by including depreciation to assess a company’s capacity to stay afloat. It measures this cash flow capacity in relation to all liabilities, rather than only debt. Apart from debt and borrowings, other liabilities include short-term ones such as accounts payable and long-term ones such as capital lease and pension plan obligations.”

Measuring cash flow rather than net income is a better determinant of solvency, especially for companies that incur large amounts of depreciation for their assets but have low levels of actual profitability. “Similarly, assessing a company’s ability to meet all its obligations – rather than debt alone – provides a more accurate picture of solvency. A company may have a low debt amount, but if its cash management practices are poor and accounts payable is increasing as a result, its solvency position may not be as solid as would be indicated by measures that include only debt.”

The formula used for computing the solvency ratio is against profitability :

Solvency ratio = (After Tax Net Profit + Depreciation) / Total liabilities

solvency ratios vary from industry to industry. However, as a general rule of thumb, a solvency ratio higher than 20% is considered to be financially sound. Generally, a lower solvency ratio of a company reflects a higher probability of the company being on default with its debt obligations.

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