Liquidity vs Solvency
The terms liquidity and solvency are both associated to a firm’s ability to repay the borrowed funds to its lenders or creditors. These terms can be easily confused and are usually misinterpreted to mean the same thing. The terms liquidity and insolvency have been frequently used in the recent past to describe the financial standing of firms that faced difficulties during the global financial crisis. The following article clearly explains the differences between these two terms with examples to clearly differentiate between the two.
What is Liquidity?
Liquidity is used to refer to a firm that has financial difficulties but is still able to repay its loans in some manner. For example, Firm A has $200 in cash, $700,000 worth of property and a loan of $600,000 to repay in a week’s time. The firm does not have sufficient liquid funds to repay the loan, and cannot sell the property to repay the loan, since the property contains their factories and office buildings. The only option left would be to obtain a loan from the bank, even though they may or may not be able to obtain a loan since that would depend on their credit standing. This puts them in risk of bankruptcy, but since they still have a huge asset of $700,000 they are safe and are able to cover some of their debts even if they have to sell the property and move to a smaller place.
What is Solvency?
Insolvency refers to a firm that has no assets or cash and is unable to obtain borrowed funds to ease debt. For example, in comparison to firm A, Firm B also has $200 in cash, $700,000 property and a loan of $600,000 to be repaid next week. However, a storm causes a lightning bolt to ignite with the factory machines causing a massive fire that destroys the entire property. Assuming the firm has not obtained an insurance cover over their assets, they now have only $200 in cash and a debt of $600,000. In this case, their only option would be bankruptcy since they have no assets to cover their debts.
Liquidity vs Solvency
Liquidity and insolvency are both deteriorating to a firm’s financial position, even though facing insolvency is much riskier as it means that the firm is bankrupt with no funds or assets in its balance sheet. Facing liquidity is less risky than insolvency, since the firm may still possess some asset that can be used to repay its debts.
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What is the difference between Liquidity and Solvency? • The terms liquidity and solvency are both associated to a firm’s ability to repay the borrowed funds to its lenders or creditors. • Liquidity is used to refer to a firm that has financial difficulties but is still able to repay its loans in some manner. Liquidity may put the firm in the risk of bankruptcy, but since the firm possesses some assets they are safe and are able to cover some of their debts even if they have to sell the assets to do so. • Insolvency refers to a firm that has no assets or cash and is unable to obtain borrowed funds to ease debt. In this case, the firm’s only option would be bankruptcy since they have no assets to cover their debts.
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