Solvency Ratios vs. Liquidity Ratios: What’s the Difference

Discover the difference between Solvency Ratios and Liquidity Ratios to understand how each set of metrics highlights a firm’s financial strength from different angles.

Solvency ratios and liquidity ratios are two of the most widely used financial metrics to assess a company’s ability to meet its obligations. While both measure financial strength, they focus on different dimensions of stability. Liquidity ratios check if the company can pay its short-term dues, whereas solvency ratios determine whether it can survive and meet long-term commitments.

Understanding both sets of ratios helps investors, lenders, and analysts evaluate whether a company is financially healthy in the immediate and long-term.

A liquidity ratio measures how easily a company can convert its current assets into cash to meet short-term obligations. These obligations are typically due within 12 months.

Liquidity ratios provide insight into operational efficiency and short-term stability.

What liquidity ratios tell you:

• Whether the company has enough cash or near-cash assets
  

• Its ability to handle sudden cash requirements
  

• Whether it relies heavily on short-term borrowing
  

• If working capital is well-managed

Below are the key liquidity ratios used across industries:

1. Current Ratio

Formula:
Current Ratio = Current Assets ÷ Current Liabilities

Interpretation:
Shows if the company has enough assets to cover short-term liabilities. A ratio above 1 is commonly observed.

2. Quick Ratio (Acid-Test Ratio)

Formula:
Quick Ratio = (Current Assets − Inventory) ÷ Current Liabilities

Focuses on highly liquid assets and excludes inventory, which may take time to convert into cash.

3. Cash Ratio

Formula:
Cash Ratio = Cash & Cash Equivalents ÷ Current Liabilities

A conservative ratio showing whether cash alone can settle short-term dues.

4. Working Capital Ratio

Formula:
Working Capital = Current Assets − Current Liabilities

Indicates operational liquidity and financial cushion.

5. Liquid Ratio (Super Quick Ratio)

Formula:
Liquid Ratio = (Cash + Marketable Securities + Receivables) ÷ Current Liabilities

Measures the company’s ability to instantly satisfy short-term liabilities.

A solvency ratio measures a company’s long-term financial strength. It checks whether the company has enough assets and earnings to meet interest payments, long-term debts, and future obligations.

What solvency ratios reveal:

• Long-term debt sustainability
  

• Ability to continue operations
  

• Whether the capital structure is healthy
  

• The company’s long-term investment potential

Solvency ratios are especially important for lenders, long-term investors, and credit rating agencies.

1. Debt-to-Equity Ratio

Formula:

Debt-to-Equity = Total Debt ÷ Shareholder’s Equity

Shows how much of the company is funded by debt.

2. Interest Coverage Ratio

Formula:

Interest Coverage = EBIT ÷ Interest Expense

Indicates whether earnings are sufficient to cover interest payments.

3. Debt Ratio

Formula:

Debt Ratio = Total Debt ÷ Total Assets

Higher ratios signal higher leverage.

4. Equity Ratio

Formula:

Equity Ratio = Shareholder’s Equity ÷ Total Assets

Shows how much of the company’s assets are financed by equity.

5. Solvency Ratio (General)

Formula:

Solvency Ratio = (Net Income + Depreciation) ÷ Total Liabilities

Represents the company’s long-term ability to meet liabilities.

Liquidity and solvency ratios are essential because they highlight different dimensions of financial risk:

Liquidity ratios matter because they:

• Help assess daily operational capability
  

• Indicate short-term risk exposure
  

• Ensure the company can meet immediate dues
  

Solvency ratios matter because they:

• Reveal the company’s long-term sustainability
  

• Show how much debt the company carries
  

• Help evaluate creditworthiness
  

• Protect investors from insolvency risks

A company’s financial health can be assessed using both metrics.

To interpret liquidity and solvency ratios effectively, keep these benchmark ranges and caution points in mind:

Liquidity ratio benchmarks:

• Current ratio: Acceptable between 1.5 – 2
  

• Quick ratio: Above 1 is usually safe
  

• Cash ratio: Often 0.2 – 0.5 (too high indicates idle cash)

Solvency ratio benchmarks:

• Debt-to-equity: 1–1.5 is acceptable but varies by industry
  

• Interest coverage: Above 2–3 indicates comfortable coverage
  

• Debt ratio: Lower is safer

Limitations while interpreting ratios:

• Industry norms differ widely
  

• Seasonal businesses may show fluctuations
  

• High liquidity may sometimes mean poor capital utilisation
  

• High solvency may mean the company is too conservative

Ratios must always be interpreted in context.

Example 1: Liquidity Ratio Case

A company has:

• Current Assets = ₹10,00,000
  

• Current Liabilities = ₹5,00,000

Current Ratio = 10,00,000 ÷ 5,00,000 = 2

This shows strong short-term liquidity.

Example 2: Solvency Ratio Case

A company has:

• Total Debt = ₹15,00,000
  

• Total Equity = ₹10,00,000

Debt-to-Equity = 15,00,000 ÷ 10,00,000 = 1.5

This indicates moderate long-term debt reliance.

Liquidity and solvency ratios together form the backbone of financial analysis. Liquidity ratios show whether a company can pay its short-term dues, while solvency ratios assess long-term stability and debt management.

Main Points:

• Liquidity = short-term health
  

• Solvency = long-term security
  

• Both ratios are essential for assessing financial resilience
  

• Ratios must be compared within industry standards
  

• A strong company performs well on both metrics

This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.