Understanding Solvency Ratios vs Liquidity Ratios for Your Startup Business
As every startup business grows, its revenue, profits, and liabilities fluctuate as well. And with technology, engineering, product development, office space, and recruiting top talent, founders require a financial measurement to show how they deploy capital responsibility in order to achieve certain financial growth milestones to investors — especially at later stages. Along with other financial reporting, this can require CEOs to work with their finance teams to understand and optimize their liquidity ratios.
Solvency (or being solvent) is an important financial metric for businesses of any size. Learn what solvency is, how it differs from liquidity, and why both are important for your business.
Solvency, like liquidity, analyzes a company’s ability to pay or meet its debt obligations, although solvency concentrates on the ability to meet long-term obligations, while liquidity focuses on the ability to pay short-term obligations. An article in the Motley Fool states that “measured by ratios, financial solvency is important for the long-term survival of any business.”
An accounting firm Indinero wrote about this topic and it points out that in finance analysts use a variety of solvency ratios to examine the health of a company, the simplest of which is assets vs liabilities. An insolvent company has more liabilities than assets, and vice versa.”
Startup founders and small business owners are often focused on the day-to-day of managing their business. However, creditors and investors use solvency ratios to evaluate the long-term viability of a company, which is vital for business owners to be aware of.
What is the Difference between Solvency VS Liquidity?
Sometimes people confuse the term liquidity with solvency, but they are different financial terms focused on different aspects of measuring a company’s financial health. Meaning:
- Solvency – examines long-term (typically a year or more) to determine whether your business is in a position to meet all of its long-term obligations well into the future to continue operating
- Liquidity – focuses on the near-term (usually less than a year) determining whether your business can pay its short-term liabilities on time, having the capability to sell assets quickly to raise cash
- It’s worth noting that liquidity and solvency are not mutually exclusive; a company that is liquid may not be solvent (and the reverse is true as well)
The Indinero article points out that a business could have high liquidity and a sufficient amount of cash on hand to pay its bills, but due to long-term debts, may not be solvent. Conversely, a business can survive being insolvent for a time, but cannot survive being illiquid.
While taking on debt or loan obligations is part of doing business, as a business owner, you’re also tasked with walking the line between giving your business a financial boost and assuming too much debt too quickly, which can lead to a drop in your credit rating or even bankruptcy. A company is considered solvent if it has more assets and cash flow than overall debt.
Here are some common assets and liabilities used to evaluate liquidity and solvency.
|Short Term (Liquidity)||Long Term (Solvency)|
|Accounts receivable||Interest payments||Natural Resources (i.e. coal or metals)||Mortgages|
(i.e. a brand or reputation)
|Prepaid expenses||Rent||Intangibles (i.e. patents or copyrights)||Pensions|
How Business Owners Can Use Solvency Ratios
Solvency ratios can be used to pitch outside investment, but it’s sometimes a delicate game. While you don’t want to mislead people about the state of your business you also want to learn how to use data to tell your company’s story.
- You should be highlighting what’s going well while acknowledging and reframing shortcomings as opportunities.
- Do you have plenty of debt but no trouble making interest payments? This indicates you’re managing cash flow wisely.
- Are your ratios above industry norms, but trending positively, then be sure to point that out.
How Investors Use Liquidity Ratios
An article in AirCFO mentions that for startups who are looking to join a venture capital portfolio, the liquidity ratio is just one of the many important measurements they can present. As a quick overview, liquidity shows an executive team’s ability to manage their debt and liability, giving insight into how the company could grow. This becomes critical as companies progress to later-stage funding rounds, which typically include some debt.
More importantly, the liquidity ratio demonstrates how viable a business is in its industry. Combined with other measurements, liquidity ratios can show that a startup is healthy, has a sound growth strategy, and can expand into a much bigger business with additional capital.
Your liquidity ratio can also be an analysis of how responsible your business is with day-to-day finances. To attract the best investors and mentors, startups should strive to have a liquidity ratio between 1.5 and 2 to 1. This tells interested investors that you have at least 50 percent more cash on hand than the startup’s current liability load.
This measurement can demonstrate to outside parties that your business is responsible with assets and is working hard to ensure long-term viability.
When companies issue equity or debt, their accounting needs become more complicated. Huckabee CPA’s outsourced accounting services are here to help growing businesses keep their finances in order. Establishing business credit can be helpful. If you’re a startup looking for outside investment, a outsourced CFO can help you account for and calculate your ratios. Have questions, feel free to reach out for a free consultation.