Blog #09 - What Is Liquidity & Solvency ? - Finance With Atul


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Saturday, April 17, 2021

Blog #09 - What Is Liquidity & Solvency ?


Liquidity vs. Solvency 


In blog #08 we look at Return on Assets. In this blog we will try to understand Liquidity and solvency. Go to previous blogs to get clear understandings.

You may hear that a company is going to insolvent this year. A large number of companies face the scenario in corporate word. In this blog we are going to look what is solvency and insolvency. Many times we see in news that a particular company is facing liquidity problems or the company is going to bankrupt now question arises what is this? In this blog we are going to understand these terms. 



Liquidity vs. Solvency


Let I have assets (I have already told about assets in previous blog. If you are new then go and check it out) this includes cash money of 100000, house of 4000000, a car of 500000 and other household items whose value is around 400000. All of this have the value of 50, 00000. Now if I talk about liabilities, suppose I have personal loan of 200000 for one year, home loan of 3200000 for 20 years, car loan of 300000 for 5 years and education load of 500000 for 5 years. All these type of loans are my liabilities whose value is 4200000.

As we already discussed that if we have to calculate net worth, we have to subtract liabilities from net worth i.e. Net worth = Assets – Liabilities. In my case my net worth is 5000000 – 4200000 = 800000 means my net worth is positive. This net worth in case of companies is known as equity. If our net worth is positive then there is no case of insolvency for us or company. Insolvency ratio comes into play if our net worth becomes negative. Suppose the value of my house becomes 3000000 by somehow while all things remain same. After mathematics the values of my assets become 4000000 while liabilities remain same. In this case my net worth is negative i.e. -200000 and this negative net worth is known as insolvency. If I have to pay all my liabilities immediately and there is no other option to pay liabilities only option is to declare bankruptcy or my net worth is negative and this called insolvency.



Same scenario happens with some companies in market in which their liabilities increases and they have declared themselves as bankrupt and this is called solvency. This solvency is overall financial position, it may be individual or a company. Now what is liquidity?


What is Liquidity?


Suppose the same situation as we discussed above i.e. the value of assets is 5000000. By definition liquidity refers to financial position of an individual or company in short term. In my case I cannot sell house immediately and this will not come under liquidity. In liquidity we have to analyze short term assets and short term liabilities. As we discussed earlier in previous blog short term means time period less than one year. Now cash that I have can be taken immediately but house, furniture and car cannot be sold immediately on the other hand I have to liabilities with less than one year. In my case home loan, car loan and education load will be excluded from the list and personal loan will enter in short term liability as I have loan period of one year. 



Here the value of short term assets is less than short term liabilities i.e. I cannot pay and this means my liquidity position is not good. Practically value of short term assets should be greater than short term liabilities and this holds for individual and companies. Here I took example of individual (myself) but it is also applicable to corporate world. So we have to analyze liquidity and solvency ratio to understand the short term and long term position of a company.


Liquidity Ratio Covers – Current ratio, quick ratio and cash ratio.


Solvency ratio covers – debt ratio, debt to equity ratio, interest coverage ratio and debt service coverage ratio.


All these ratios will be covered in next blog so stay updated and follow me on facebook and twitter.



Read Blog #01

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Read Blog #03

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Read Blog #05

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Read Blog #08




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