Question

Summarize the issues one should address in the analysis of:

Short term liquidity and Long-term solvency

Answer 1

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-term financial commitments. Liquidity refers to an enterprise's ability to pay short-term obligations; the term also refers to a company's 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, but it may be heading for financial disaster down the road.

Solvency and liquidity are equally important, and healthy companies are both solvent and possess adequate liquidity. A number of liquidity ratios and solvency ratios are used to measure a company's financial health, the most common of which are discussed below.

Liquidity Ratios

• Current ratio = Current assets / Current liabilities

The current ratio measures a company's ability to pay off its current liabilities (payable within one year) with its current assets such as cash, accounts receivable and inventories. The higher the ratio, the better the company's liquidity position.

• Quick ratio = (Current assets – Inventories) / Current liabilities

                 = (Cash and equivalents + Marketable securities + Accounts receivable) / Current liabilities

The quick ratio measures a company's ability to meet its short-term obligations with its most liquid assets and therefore excludes inventories from its current assets. It is also known as the "acid-test ratio."

• Days sales outstanding (DSO) = (Accounts receivable / Total credit sales) x Number of days in sales

DSO refers to the average number of days it takes a company to collect payment after it makes a sale. A higher DSO means that a company is taking unduly long to collect payment and is tying up capital in receivables. DSOs are generally calculated quarterly or annually.

Solvency Ratios

• Debt to equity = Total debt / Total equity

This ratio indicates the degree of financial leverage being used by the business and includes both short-term and long-term debt. A rising debt-to-equity ratio implies higher interest expenses, and beyond a certain point, it may affect a company's credit rating, making it more expensive to raise more debt.

• Debt to assets = Total debt / Total assets

Another leverage measure, this ratio quantifies the percentage of a company's assets that have been financed with debt (short-term and long-term). A higher ratio indicates a greater degree of leverage, and consequently, financial risk.

• Interest coverage ratio = Operating income (or EBIT) / Interest expense

This ratio measures the company's ability to meet the interest expense on its debt with its operating income, which is equivalent to its earnings before interest and taxes (EBIT). The higher the ratio, the better the company's ability to cover its interest expense.

Calculating Liquidity and Solvency Ratios

Let's use a couple of these liquidity and solvency ratios to demonstrate their effectiveness in assessing a company's financial condition.

Consider two companies – Liquids Inc. and Solvents Co. – with the following assets and liabilities on their balance sheets (figures in millions of dollars). We assume that both companies operate in the same manufacturing sector, i.e. industrial glues and solvents.

Balance Sheet (in millions of dollars)	Liquids Inc.	Solvents Co.
Cash	$5	$1
Marketable securities	$5	$2
Accounts receivable	$10	$2
Inventories	$10	$5
Current assets (a)	$30	$10
Plant & equipment (b)	$25	$65
Intangible assets (c)	$20	$0
Total assets (a + b + c)	$75	$75
Current liabilities* (d)	$10	$25
Long-term debt (e)	$50	$10
Total liabilities (d + e)	$60	$35
Shareholders' equity	$15	$40

*In our example, we assume that "current liabilities" only consist of accounts payable and other liabilities, with no short-term debt. Since both companies are assumed to have only long-term debt, this is the only debt included in the solvency ratios shown below. If they did have short-term debt (which would show up in current liabilities), this would be added to long-term debt when computing the solvency ratios.

Liquids Inc.

Current ratio = $30 / $10 = 3.0

Quick ratio = ($30 – $10) / $10 = 2.0

Debt to equity = $50 / $15 = 3.33

Debt to assets = $50 / $75 = 0.67

Solvents Co.

Current ratio = $10 / $25 = 0.40

Quick ratio = ($10 – $5) / $25 = 0.20

Debt to equity = $10 / $40 = 0.25

Debt to assets = $10 / $75 = 0.13