What are liquidity and solvency ratios?


Quick Answer

Liquidity ratios refer to a firm's ability to meet its immediate financial obligations in terms of cash on hand and assets that can be sold quickly, while solvency ratios compare a firm's total assets to its total obligations, even into the future. Both are measures of a firm's financial health.

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Full Answer

When calculating a company's liquidity ratio, current assets are divided by current liabilities, with current liabilities being defined as the money a firm must pay within one year. Current assets don't include all of a firm's basic inventory, only such assets as marketable securities and the amount of money immediately owed by individuals or other firms. A bad indicator for the liquidity ratio is a high daily sales outstanding ratio, which indicates that the firm is taking too long to collect money it's owed.

Calculating solvency ratio is a bit simpler, in that it's a firm's total assets divided by its total liabilities. Total assets include all inventories. A lower solvency ratio indicates that a business is entering into a large amount of debt to continue its operations. If the ratio continues to lower, the firm may have its credit rating lowered, resulting in higher interest rates and a reduced ability to borrow money.

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