MANAGING LIQUIDITY AND SOLVENCY

Assignment #1

1. Compare and contrast “liquidity” and “solvency”. (10 points)

2. Discuss at least three financial ratios that may be used to manage liquidity
and/or solvency. You may use examples for clarity. (15 points)

Liquidity is the ability of an enterprise to pay short-term obligations such as bills and
debts as well as the capability of a company to quickly sell its assets to raise cash. In general, it
refers to how fast, efficient and cheap to convert a security or an asset into a cash. Universally,
cash is considered to have the highest liquidity among all of the assets for the very reason that it
can be easily converted into other assets. On the otherhand, Solvency is a company’s ability to
meet long-term debts or obligations to continue operating into the future. It tells if a company
can meets its obligations while achieving its long-term goals.
Liquidity and solvency have been called the “heavenly twins” of banking. Basically,
liquidity is a “short-term” solvency but with a distinction. A company may be solvent but not
liquid enough for it to experience difficulties in securing short-term finances. On the contrary, a
company may have plenty of cash which means it has higher liquidity but has unstable long-
term prospects when investing with the purpose of expanding the growth. Ergo, both liquidity
and solvency help an entity to keep track of what’s going to happen as well as the peak of its
capacity as an economic entity.

The term “financial ratios” pertains to the usage of financial figures to gain significant
information about a specific company. The main purposes of analysis of financial ratios are :
first, to track the performance of a company through the process of determining the individual
financial ratios per period and tracking the change in their values over time for the intension of
spotting trends that may be used in developing a company. Secondly, to make comparative
judgments with the performance of a company through comparison of financial ratios with that of
major competitors to know whether a company is performing better or worse than the industry at
average.

There are more than three financial ratios that can be used in order to manage the
company’s liquidity and/or solvency. First, Liquidity Ratios are financial ratios that measure a
company’s ability to repay both short-term and long-term obligations. It gives investors an idea
of how efficient the company’s operations are. Second, Leverage Financial Ratios measure the
amount of capital that comes from debt or obligations and used to evaluate a company’s debt
levels. To know these, a company may use debt ratio, interest coverage ratio and debt-equity
ratio. Third, Efficiency Ratios or also known as Turnover Ratios, are used to measure how well
a company is in terms of utilizing its assets and resources through asset turnover ratio,
inventory turnover ratio and days sale inventory ratio.

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