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Liquidity and Solvency

Liquidity refers to a company's ability to meet short-term (under 12 months) debt obligations and is measured using ratios like current ratio, quick ratio, and days sales outstanding. Solvency refers to the ability to meet long-term debt and is measured using debt-to-equity ratio, debt-to-assets ratio, and interest coverage ratio, with higher ratios generally indicating better liquidity and solvency positions. The document defines key liquidity and solvency ratios and what they measure regarding a company's financial health.

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Genelle Soriano
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334 views2 pages

Liquidity and Solvency

Liquidity refers to a company's ability to meet short-term (under 12 months) debt obligations and is measured using ratios like current ratio, quick ratio, and days sales outstanding. Solvency refers to the ability to meet long-term debt and is measured using debt-to-equity ratio, debt-to-assets ratio, and interest coverage ratio, with higher ratios generally indicating better liquidity and solvency positions. The document defines key liquidity and solvency ratios and what they measure regarding a company's financial health.

Uploaded by

Genelle Soriano
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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MANAGING LIQUIDITY AND SOLVENCY

 
Liquidity is a company’s ability to meet its short-term debt obligations. Short-term
debt is defined as any debt that will be paid back within 12 months.
 
Liquidity Ratios
A company with adequate liquidity will have enough cash available to pay its bills. Here
are some of the most popular liquidity ratios.
 Current Ratio - 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.
 
Current ratio = Current assets / Current liabilities
 
 Quick Ratio - 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."
 
Quick ratio = (Current assets – Inventories) / Current liabilities
Quick ratio = (Cash and equivalents + Marketable securities + Accounts
receivable) / Current liabilities
 
 Days Sales Outstanding (DSO) - 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.
 
Days sales outstanding (DSO) = (Accounts receivable / Total credit sales) x
Number of days in sales
 
Solvency is a company’s ability to meet its long-term debt obligations. Long-term
debt is defined as any financing or borrowed monies that will be paid back after 12
months.
 
Solvency Ratios
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. Here are some of the most popular solvency
ratios.
 Debt-to-Equity (D/E) - 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 ratings, making it
more expensive to raise more debt.
 
Debt to equity = Total debt / Total equity
 
 Debt-to-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.
 
Debt to assets = Total debt / Total assets
 
 Interest Coverage Ratio - This ratio measures the company's ability to
meet the interest expense on its debt, 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.
 
Interest coverage ratio = Operating income (or EBIT) / Interest expense

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