A property developer
Whose land is worth far more than its borrowings is solvent, and can still be unable to pay an instalment.
Solvent, illiquidNet Worth & Solvency Glossary · Solvency & Courts
Liquidity Versus Solvency in a Certified Financial Position
noun · a question of timing, not of size · measured over the near term
Definition
In accounting, liquidity is the ability to meet obligations that fall due in the near term from resources that can be turned into cash in the near term.
It is a question of timing, not size. Solvency, by contrast, asks whether everything owned exceeds everything owed.
Two questions, not one
Liquidity asksCan what is due next month be paid next month?From resources that can be turned into cash in the near term.
Solvency asksCould everything owed be paid if everything owned were sold?The longer view: the whole structure against the whole debt.
Both can be true at once. A business can be profitable and short of cash at the same time; a person can own two flats and hold no bank balance.
Meaning
01What liquidity measures over the near term
A business with large assets but nothing it can turn into cash this month has a liquidity problem, however wealthy it looks on paper. The near term is usually read as the period used for the current and non-current split in the balance sheet. Current assets are those expected to turn into cash within that window in the ordinary course of business, and current liabilities are those due within it. That is why stock counts as current even though selling it takes effort, and why a long-dated deposit does not.
A business can also be profitable and short of cash at the same time. Profit is earned over a period, while cash arrives when customers pay, so a fast-growing business can run out of cash while making money.
Highly liquid
For an individual, the idea is the same as for a business
- Bank balances
- Deposits that can be broken
- Listed securities
Not liquid, whatever the value on paper
Worth counts toward solvency, not toward next month
- Property
- Unlisted shares
- Money owed by others
The common trap: a deposit under lien. The balance exists, but it cannot be drawn.
Solvent or not, liquid or not: four positions
Concept only, no figuresLiquid
Illiquid
Solvent
Solvent and liquidEverything owned exceeds everything owed, and next month's dues can be met from cash and near-cash.Both questions answered yes.
Solvent and illiquidTwo flats and no bank balance. Land worth far more than the borrowings, and an instalment that cannot be paid.The case this entry is about.
Insolvent
Insolvent and liquidCash to hand for next month, but everything owed exceeds everything owned.Passes the timing question, fails the size question.
Insolvent and illiquidNeither next month's dues nor the whole debt can be met.Both questions answered no.
Liquidity is the column a reader is in; solvency is the row. A certified figure that answers the row does not answer the column.
Why the figure can fail
02Why a solvent applicant can still fail a liquidity test
Solvency and liquidity ask different questions.
SolvencyCould everything owed be paid if everything owned were sold?
LiquidityCan what is due next month be paid next month?
An individual with two flats
Who holds no bank balance is solvent and illiquid.
Solvent, illiquidA visa office
Asking whether a trip can be funded is asking the second question, not the first.
Asks about liquidityThis is why applicants who present a strong net worth figure are sometimes told it does not answer the condition. Where a tender or lender condition names a period or asks about funds available, it is asking about liquidity.
A solvency certificate is framed to the question actually asked, and it shows what can be reached as well as what is owned.
How banks measure it
03Current and quick ratios Indian banks compute from audited statements
Banks usually measure a business's liquidity with two ratios from the audited financial statements.
Current ratio=current assets÷current liabilities
Current ratio
A result above one means current assets exceed what falls due in the near term.
Quick ratio=(current assets − stock)÷current liabilities
Quick ratio
Stock is removed because it is usually the slowest current asset to turn into cash and the first to lose value under stress.
Passes current, fails quickA business that passes the current ratio but fails the quick ratio is carrying its liquidity in stock, which a lender treats with caution.
Read against the industry, as at a dateA retailer with heavy stock and a consultancy with none can both be sound. Because both ratios come from audited figures as at a date, the date of the accounts matters to the assessment.
A bank "liquidity certificate" for an account holder is a different document, a bank's confirmation of balances, and is not covered here. How a bank's liquidity or solvency certificate differs from a CA's is set out in its own article.
Written by Subham Jhunjhunwala · Reviewed by CA Sundram Gupta
This entry describes general accounting practice. The document that sets the condition governs what is measured.
Need help with a certificate that uses liquidity? See our Solvency Certificate.Framed to the question actually asked, showing what can be reached as well as what is owned.