Solvency vs. liquidity

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For a business to be successful, it must be able to properly manage its finances. This means more than simply having enough capital to pay expenses. As organizations grow, they accrue debt. An efficiently run business is capable of managing that debt, minimizing the risk to that organization.

Several businesspeople listen to another who leads a meeting

Finance managers often look at their organization’s liquidity and solvency when assessing the ability to pay debts. Although both areas help strategize debt coverage, one focuses on addressing debts in the short-term through cash, while the other helps establish long-term financial stability.

Having a strong grasp on the balance sheet of an organization helps finance managers to confirm both liquidity and solvency. It also alerts them to gaps in cash and assets that would prohibit proper debt coverage. Being able to interpret the balance sheet correctly and strategize solutions for when liquidity or solvency are at risk requires a comprehensive background in financial principles, the type which can be enhanced with a master’s degree in business administration. An MBA builds upon existing knowledge and experience to improve finance professionals’ adaptability in an often-demanding work environment.

What are liquidity and solvency?

Although fundamentally different, liquidity and solvency are both connected to the ability of an organization to meet its debt obligations on time and in a way that doesn’t lead to unmanageable losses. Companies put short-term strategies into place to maintain liquidity and long-term strategies for solvency. No single resource completely quantifies risk when looking at these two elements, so finance professionals use several measurement tools to assess an organization’s current debt situation and provide a forward-looking analysis for the future.

Developing and implementing strategies related to liquidity and solvency is usually a collaborative effort of senior management within an organization. Executives in finance, operations, and technology establish policies on issues such as the composition of assets and liabilities. Liquidity and solvency needs should be taken into account under both normal conditions and times of financial stress to fully plan for any situation. By looking at all scenarios related to the availability of funds to pay down debt, an organization can identify and prepare for potential funding issues before they actually occur. As liquidity and solvency strategies are finalized, it’s up to the management team to ensure all business units affected are aware of the plans.

Solvency vs liquidity

Liquidity is often a more involved strategy than solvency due to it being a short-term measurement of business. Managing risk associated with liquidity is a necessary component of a broader business-wide risk management system that should be in place to help maintain operations. Assessing prospective funding needs and ensuring enough money is available at the right times to handle debt helps keep risk low. Because liquidity is associated with the short term, regular tasks that can be done to manage risk include:

  • Monitoring and assessing current and future debt obligations
  • Planning for unexpected funding needs
  • Addressing daily liquidity obligations
  • Preparing to withstand any periods of liquidity stress

As risk is established and effectively managed, the next step is to prepare enough sources to continue to meet liquidity needs. This task includes looking to several income sources, such as:

  • Existing assets: bringing in cash from interest or principal payments from existing assets, which can include the collection of service fees or funds from various transactions and sale of certain assets.
  • Debt obligations: obtaining cash to manage debt through this route is highly dependent on an organization’s perceived financial condition and public credit standing. It might not be an ideal source for a younger business or one that is emerging from financial difficulties.
  • Equity: this source has the potential to be a costlier choice as well as a lengthier arrangement for managing liquidity than the other two options.

Solvency

A business is considered solvent when it’s able to pay down long-term debt and associated interest. Coupled with other elements of a financial ratio analysis, solvency helps an organization determine if it has the means to survive long term.

Maintaining solvency and earmarking appropriate funding sources are just two of the steps in the overall process. Solvency must also be calculated. Often, solvency is measured as a ratio of assets to liabilities. Two commonly used ratios are the current ratio and the quick ratio. The current ratio takes an organization’s current assets—cash, accounts receivable, inventory and prepaid expenses—and divides that number by the total current liabilities. Ideal for an emergency situation, the quick ratio uses only cash and accounts receivable as the current assets since those are the only two assets available quickly. Cash and accounts receivable are then divided by current liabilities.

Building expertise calculating liquidity and solvency

While overall responsibility for managing and maintaining an organization’s liquidity and solvency falls on senior management, it’s often a company’s financial manager or chief financial officer with the expertise needed to properly evaluate and manage debt. Becoming a high-level executive within finance typically requires a strong educational and professional background. Oftentimes a hiring manager will look for candidates to have a degree in business administration.

The online Master of Business Administration at the University of Alabama at Birmingham includes coursework on topics relevant to build skills in foundational business principles like operations and organization management, alongside those relevant skills for pursuing a career in finance. Courses such as Accounting and Finance for Managers and Treasury Management give a breakdown of the basic concepts of financial accounting while also going into detail on topics like financial planning, corporate liquidity, and short-term financial policy issues.

From business insights and analytics to management techniques and leadership styles, the online MBA degree from University of Alabama at Birmingham can help professionals enhance their business acumen. Learn more by contacting an enrollment advisor today.

Recommended Reading:

What is accounts receivable?

How to narrow down a career with an MBA

How an MBA can help you prepare for hurdles in the financial industry

Sources:

What is liquidity risk? by Federal Reserve Bank of San Francisco

What solvency is in a business by The Balance, Small Business

Liquidity Versus Solvency—Deconstructed for Twenty somethings by CNBC

Occupational Outlook Handbook — How to Become a Top Executive by the U.S. Bureau of Labor Statistics

Online Master of Business Administration – University of Alabama at Birmingham