Solvency and liquidity are two important terms that small business owners should know. Some would accidentally mistake one for the other because their definition is quite similar. However, there are distinct differences that distinguish solvency from liquidity and vice-versa.
Here are some of the answers to the question “what is liquidity in business?” and liquidity’s differences with solvency.
Long-Term vs. Short-Term
Solvency reveals your small business’ capacity to continue long-term operations. If your company is having solvency problems, your chances of closing increase as the months go on. Liquidity is about your company’s ability to pay immediate current liabilities and dues using current assets. Liquidity focuses on the short-term needs of your small business. Solvency and liquidity are both important to the success or failure of your company.
Ratios Used for Assessment
As an owner, you need to be always aware of the financial standing of your company. Knowing different financial ratios such as assessing solvency and liquidity allow you to allocate resources effectively. It also enables you to determine profitability. The ratios you use allows you to make plans about the present and the future of your business.
The ratios used to determine liquidity include current ratio, quick ratio and acid test ratio. You get the solvency ratio of your business by dividing the total of net after-tax income and non-cash expenses with the total of short-term liabilities and long-term liabilities.
Both ratios have an effect on each other and the outlook of your company. High short-term liquidity may not mean long-term solvency. On the other hand, long-term solvency still provides you with enough time to remain liquid in the short term.
You have to weigh the risks of settling immediate obligations to manage liquidity and determining the long-term solvency of your business. Poor liquidity in the short run is manageable but may have a negative impact on your creditworthiness. Sell some assets or only invest in ones that you can easily turn into cash to pay obligations.
Solvency problems present a tougher challenge for small business owners. This may lead to bankruptcy, if you fail to resolve this problem. This is when details matter. Keep your accounting books updated to determine if you are having financial troubles on a regular basis. Improve sales, move inventory quickly, make forecasts and make prudent long-term investments.
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