Liquidity vs solvency: Key differences for your small business

Published Friday 24 October 2025

Table of contents

• Liquidity vs solvency: key differences
• What is solvency?
• What is liquidity?
• Solvency ratios for calculating the solvency of a small business
• Liquidity ratios for calculating the liquidity of a small business
• Why are liquidity and solvency ratios important for small businesses?
• Tips to boost your liquidity
• Managing your financial health with confidence
• FAQs on liquidity and solvency

Key takeaways

• Monitor both liquidity ratios (current, quick, and cash ratios) monthly and solvency ratios (debt-to-equity, debt-to-asset, and interest coverage) quarterly to maintain a complete picture of your financial health and identify potential problems before they become critical.

• Prioritize liquidity improvements by speeding up collections through automated invoice reminders, negotiating longer payment terms with suppliers, and reducing inventory levels to free up cash for immediate obligations.

• Use solvency ratios strategically when seeking financing, as lenders offer better terms to businesses with strong debt-to-equity and interest coverage ratios, making these metrics essential for securing growth capital.

• Recognize that a business can be liquid but not solvent, so balance short-term cash management with long-term debt reduction to ensure both day-to-day survival and sustainable growth.

Liquidity vs solvency: key differences

While both liquidity and solvency measure a business's financial health, they focus on different timeframes. Understanding the distinction is key to managing your finances effectively.

Liquidity looks at your short-term ability to pay bills as they come due. It answers the question: do you have enough cash or assets you can quickly convert to cash to cover your immediate obligations? Think of it as your business's day-to-day financial pulse.

Solvency, on the other hand, is about your long-term financial stability. It assesses whether your assets are greater than your liabilities, indicating if your business can meet its long-term debts and stay operational for years to come. It answers the question: is your business built to last?

What is solvency?

Solvency is your business's ability to pay long-term debts and remain financially stable over time. If your business is solvent, you have enough assets to cover all debts as they come due.

This financial strength offers three key benefits:

• Survival during downturns: You can weather economic challenges without filing bankruptcy
• Access to credit: Lenders view solvent businesses as lower-risk borrowers
• Growth opportunities: Financial stability lets you invest in expansion with confidence

If your business is solvent, you have enough assets and resources to pay your debts as they come due. You can survive economic downturns or unexpected expenses without filing for bankruptcy. You likely have enough cash on hand to cover short-term obligations.

Solvency means that your business is financially stable and expected to last over the long term. It can affect your creditworthiness. Lenders, investors, and suppliers may assess your solvency when deciding whether to give you credit or do business with you.

Solvency ratios help you see if you can pay your long-term debts and interest. Common solvency ratios include the debt-to-equity ratio and the debt-to-asset ratio.

What is liquidity?

Liquidity measures how quickly you can convert assets into cash to pay immediate expenses. Highly liquid assets include cash, bank deposits, and marketable securities that convert to cash within days.

Why liquidity matters: You can pay bills on time, avoid late fees, and seize time-sensitive opportunities without scrambling for funds.

Accounting liquidity shows whether you can pay short-term debts (due within 12 months) without selling assets at a loss.

Strong liquidity helps you:

• Pay bills on time: Avoid late penalties and maintain good vendor relationships
• Handle emergencies: Cover unexpected expenses without borrowing
• Maintain operations: Keep your business running smoothly during cash flow gaps

In assessing your company's liquidity, you look at your current assets. You also take into account your working capital and your cash flow.

You can use liquidity ratios to measure your liquidity and determine if you can pay your short-term debts.

Solvency ratios for calculating the solvency of a small business

Here are the solvency rations for calculating a small business' solvency.

Debt-to-equity ratio

Debt-to-equity ratio shows whether you rely more on borrowed money or owner investment to fund your business. A lower ratio means greater financial flexibility and less risk.

Formula: Total debt ÷ Total equity = D/E ratio

Debt includes:

• Short-term loans and credit lines
• Long-term debt and equipment financing
• Accounts payable and accrued expenses

Equity includes:

• Your initial investment in the business
• Retained earnings (profits kept in the business)
• Additional capital contributions

The D/E ratio gives you a number that reflects your debt-to-equity ratio. A lower number means your business relies more on equity than debt. This can also mean you have more financial flexibility.

A higher number suggests you rely more on debt than equity. This may mean you have more financial obligations, so it's important to monitor your ratio, especially during economic changes.

The specific risk might vary by industry. Industries that must invest in new equipment or plants may have a higher debt-to-equity ratio than other industries. You may also see a higher ratio if you use debt to help your business grow.

Debt-to-asset ratio

The debt-to-asset ratio tells you how much of your assets are paid for with borrowed money.

The formula for calculating the debt-to-asset ratio is:

Debt-to-asset ratio = Total debt divided by total assets

In this formula, the debt includes short-term debt and long-term obligations. These include loans, lines of credit, and other financial liabilities. Assets include all current assets and noncurrent assets. This could include cash, accounts receivable, and inventory.

The result is given as a percentage. For example, a result of 0.6 indicates 60%. This means that 60% of your assets are financed by debt. A higher ratio indicates a significant portion of your assets are funded through debt. This means you have higher financial obligations to cover.

A good ratio depends on your industry. Some industries, like those needing expensive equipment, may have higher debt-to-asset ratios.

Interest coverage ratio

The interest coverage ratio, sometimes called the times interest earned ratio, shows if you can pay interest on your debts with your operating income.

The formula is:

Interest coverage ratio = Operating income divided by interest expenses

Operating income refers to your earnings before income tax, interest, and non-operating expenses. Interest expenses include all interest payments your business must make during a specific period.

A higher ratio means you can more easily pay interest on your debts. For example, a ratio of 6 means you earn six times what you need to cover interest payments. A rising ratio also shows your business is getting better at generating income.

A higher interest coverage ratio shows strong financial health and lower risk. Lenders and investors may use this ratio when deciding to offer you credit or invest in your business.

Liquidity ratios for calculating the liquidity of a small business

There are three common ratios for calculating liquidity for small businesses.

Current ratio

The current ratio is also called the working capital ratio. It measures your ability to cover short-term financial obligations with your short-term assets.

The formula is:

Current ratio = Current assets divided by current liabilities.

Current assets are those that can be converted into cash or used up within 12 months. This includes cash, accounts receivable, and inventory. Current liabilities are debts that should be paid within 12 months. This includes accounts payable, short-term loans, and payroll.

The current ratio is a snapshot of your ability to pay debts. It shows how your assets compare to your liabilities. A ratio above 1 means you can pay your short-term debts. For example, a ratio of 2 means you have twice as much in current assets as you owe in current liabilities.

The current ratio gives you an idea of your liquidity, working capital, and financial stability.

Quick ratio

The quick ratio is also known as the acid test ratio. It's more conservative than the current ratio because inventory is removed from the equation. Inventory is more difficult than other assets to turn into cash.

The quick ratio formula is:

Quick ratio = (Current assets – inventory) divided by current liabilities

If your ratio is less than 1, you may have trouble covering short-term debt. A ratio of 2 or higher usually means you have strong liquidity.

Cash ratio

The cash ratio shows if you can cover immediate debts using only cash and cash equivalents. It's the most conservative of the three calculations.

The formula is:

Cash ratio = (Cash + Cash equivalents) divided by current liabilities

In this formula, cash equivalents are highly liquid investments that can be converted to cash in three months or less. A ratio of 0.5 or higher is usually healthy. The higher your ratio, the easier it is to cover short-term debts with cash.

Why are liquidity and solvency ratios important for small businesses?

Liquidity ratio

Liquidity ratios reveal whether you can pay your bills without scrambling for cash. These calculations help you:

• Prevent cash shortages: Identify potential payment problems before they happen
• Optimize working capital: Balance having enough cash without tying up too much money
• Make strategic decisions: Know when you have excess funds for growth investments
• Compare performance: Benchmark against industry standards and competitors

Understanding your liquidity helps you make strategic business decisions. For example, if you have excess liquidity, you can consider investing in growth opportunities or paying down debt.

You can compare your liquidity ratios to industry benchmarks and competitors to see how your business stacks up.

Solvency ratio

Solvency ratios predict your business's long-term survival by measuring debt against assets and equity. These metrics help you:

• Secure better loans: Lenders offer lower interest rates to businesses with strong solvency
• Attract investors: Higher ratios signal lower investment risk
• Plan for growth: Understand your debt capacity before expanding
• Weather downturns: Assess your ability to survive economic challenges

Investors and lenders use solvency ratios to assess the solvency risk of a business and make decisions. A higher solvency ratio is seen as a lower risk of default. This makes it easier for you to secure loans or attract investors.

Reviewing your solvency ratios helps you decide if you should take on more debt. If your ratio is healthy, you may want to grow your business. If it's low, focus on increasing equity or reducing debt.

Tips to boost your liquidity

You can boost your liquidity by converting assets to cash faster and managing payment timing. Here are some steps you can take:

• Speed up collections: Use accounting software like Xero to send automated invoice reminders and offer early payment discounts
• Extend payment terms: Negotiate longer payment windows with suppliers while maintaining good relationships
• Reduce inventory: Keep stock levels lean and implement just-in-time ordering to free up tied-up cash
• Cut unnecessary expenses: Eliminate non-essential spending and find more cost-effective suppliers
• Increase sales efficiency: Focus on high-margin products and expand your customer base without increasing operating costs
• Managing your financial health with confidence

Understanding both liquidity and solvency gives you a complete picture of your business's financial health. Regularly tracking these metrics helps you make smarter decisions, from managing daily cash flow to planning for long-term growth.

With clear insights into your finances, you can run your business with more confidence. Xero makes it easy to track these ratios in real time, so you can focus on what's next. Get one month free of Xero.

FAQs on liquidity and solvency

Here are some common questions small businesses may have about liquidity and solvency.

Can a business be liquid but not solvent?

Yes. A business can have enough cash for immediate bills but still have too much long-term debt. It's important to manage both liquidity and solvency for long-term success.

What's the difference between liquid assets and solvency?

Liquid assets are items you can convert to cash quickly to pay short-term bills. Solvency is a broader measure of your business's ability to pay all its debts, both short-term and long-term, over time.

Which is more important for small businesses: liquidity or solvency?

Both are critical, but they serve different purposes. Liquidity is essential for day-to-day survival, while solvency is key for long-term stability and growth. You need both to run a healthy business.

How often should I calculate these ratios?

It's a good practice to review your liquidity ratios monthly as part of your regular financial check-up. Solvency ratios can be reviewed quarterly or annually, or whenever you're considering taking on significant new debt or making major investments.