Understanding Company Finances: Liquidity, Solvency, and Debt
Liquidity
Liquidity is the ease with which an asset can be converted into cash without significant loss of value. It represents the ability of a company to meet its short-term payment obligations to suppliers, workers, banks, etc. A company has liquidity if it can meet all its short-term payment obligations.
When a company lacks liquidity, it previously was said to be in default. Now, it enters into an arrangement with creditors. This situation is overseen by a judge. A group of experts, appointed by the court, is responsible for drafting an agreement to pay creditors and, to the extent possible, ensure the survival of the company.
To analyze liquidity, we will use several indicators:
Working Capital
Working capital is the amount that remains after paying short-term debts and helps us to keep the business running, making money.
- Working Capital = Assets – Current Liabilities (There is another formula)
- If the fund is positive, there is a surplus or buffer on short-term debt. The larger the working capital, the greater the assurance that the company can meet its debts. It is an indicator that the company has liquidity.
- A working capital near zero or negative indicates a lack of liquidity and that the company is in financial difficulties.
Liquidity Ratio
A ratio is a relationship between economic figures that provides a diagnosis of some aspect of the company.
- Liquidity Ratio = Current Assets / Current Liabilities
This ratio analyzes the company’s ability to meet its payment obligations, i.e., its liquidity. Its value should range between 1 and 2. It must always be greater than unity. A value less than 1 represents a situation of insolvency. For example, a value of 1.75 means that for every dollar of debt, we have 1.75 euros in cash, money immediately available to meet that debt.
If we conduct a more thorough analysis of the company’s liquidity, we would have to subdivide the current assets into three smaller pools of assets:
- Stocks: Products that would be sold to raise money.
- Receivables: Assets that would take little time to convert into money: Customers, debtors, short-term investments, etc.
- Available: Immediately available money to pay: Cash and cash equivalents.
Here are other ratios widely used to measure liquidity:
- Acid Test = (Cash + Receivables) / Current Liabilities. Its ideal value is between 0.8 and 1.
- Cash Ratio = Cash / Current Liabilities
Solvency
Solvency is the ability of a company to meet all its debts. A company is solvent if it has enough resources to pay all its debts in the long run. When a company has no credit, it previously was said to be in receivership or bankruptcy. Now, it enters into an arrangement with creditors. This situation is overseen by a judge. A group of experts, appointed by the court, is responsible for drafting an agreement to pay creditors and, to the extent possible, ensure the survival of the company.
Solvency is measured with the solvency ratio:
- Solvency Ratio = Assets / Liabilities; > 1 solvent, < 1 bankruptcy
This ratio represents the security offered to the company’s creditors. It tells us whether or not the company has sufficient resources to meet its debts, that is, if it has credit. Its value must always be greater than unity, since a value less than one would indicate that the company is in a bankruptcy situation. For example, a value of 3 means that for every dollar of debt, we have 3 euros to cover it.
Debt (Leverage)
This indicates the weight that debt or external financing has over equity. It is especially interesting when we go to the bank to get money for the company. Banks pay close attention to this ratio.
- Debt Ratio = Liabilities / Equity; > 1 in debt, < 1 little debt, 0 debt-free
The optimal value in enterprises (Golden Rule) is considered to be 1. If less than one, the company has little debt. If it exceeds the value of 1, it indicates that the company is indebted and is an indicator of financial instability. The smaller the value, the less indebted the company is. For example, a value of 2 means that for every euro that the partners have, the company has borrowed 2 euros in debt.