Solvency and liquidity: What do they mean for small business owners?

Published Saturday 25 November 2023

Solvency and liquidity are important for small business owners to understand. Both terms are related to your business’s financial health and its viability, but they refer to different aspects. Solvency is your ability to pay long-term debts, while liquidity refers to more short-term obligations.

Both solvency and liquidity can affect your cash flow. In a recent Xero survey, 48% of US small business owners said inflation had a high or extreme impact on their cash flow over the past six months, with 44% expecting a similar impact over the next six months.

What is solvency?

Solvency is your small business’s ability to pay its long-term debts, stay in business, and become profitable. If your business is solvent, you can pay your long-term financial obligations. It indicates financial stability over the long term.

If your business is solvent, you have enough assets and resources to pay your debts as they come due. You can financially survive economic downturns or unexpected expenses without filing for bankruptcy. It’s also likely you have sufficient 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.

You can use solvency ratios to measure your solvency. These are financial ratios that help you calculate if you can pay your long-term debts and interest. Ways to calculate your solvency ratio include the debt-to-equity ratio and the debt-to-asset ratio.

What is liquidity?

Liquidity refers to your company's assets and how easily they can be converted to cash. A liquid asset can quickly and easily be converted into cash. Liquid assets include stock, bonds, and shares. If your company is highly liquid, you can convert assets into cash without significantly affecting their value.

Accounting liquidity reflects your company’s ability to pay short-term obligations and regular expenses, for example, whether you have enough cash or liquid assets to pay your bills and loans without delay, and without losing money on your assets. Understanding your liquidity is crucial for maintaining your business’s financial health.

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.

Why are liquidity and solvency ratios important for small businesses?

Liquidity ratio

Knowing your liquidity ratio helps you track the financial health of your business to meet your obligations. You’ll be able to assess whether you have enough available assets to cover immediate bills. You’ll also be able to optimize your working capital and prevent a cash flow crisis.

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.

Small businesses can compare their performance against other similar businesses in their industry. You can compare your liquidity to industry-specific benchmarks to see whether you’re in line with industry norms. You could also compare your liquidity ratios with your competitors to gain a competitive advantage.

Solvency ratio

Your solvency ratio can be an indicator of the financial health of your business. By knowing your solvency ratio, you can gauge whether you’re likely to remain financially viable in the future. This includes withstanding changes in market conditions or economic downturns.

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.

Analyzing the ratio tests for solvency can help you make better management decisions about whether to take on more debt. If your solvency ratio is healthy, you might decide to pursue growth opportunities. If it’s low, you might focus on increasing equity or reducing debt.

Solvency ratios for calculating the solvency of a small business

Debt-to-equity ratio

The debt-to-equity ratio measures the proportion of your business’ financing that comes from debt compared to your equity. It’s often abbreviated as a D/E ratio, and it evaluates how your business is financed.

The formula is:

Debt-to-equity ratio = Total debt divided by total equity

In this formula, debt means borrowed funds. Types of debt include short-term debt, long-term debt, accounts payable, and accrued liabilities.

In a small business, total equity refers to owner equity. That’s the money invested by you and the retained earnings not distributed to owners or shareholders. In a public company, equity refers to shareholder equity.

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 might also indicate a higher level of financial risk because you have more debts to pay. This can be risky in economic downturns.

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. Additionally, you may have periods of higher ratio if you’re using debt to strategically fund growth.

Debt-to-asset ratio

The debt-to-asset ratio tells you how much of your assets are financed through debt. This shows you how much financial leverage your business uses.

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 score depends on the industry. The higher the ratio, the higher the risk. Some industries that need expensive equipment may have higher debt-to-asset ratios.

Interest coverage ratio

The interest coverage ratio is also known as the times interest earned ratio. It measures your ability to cover interest payments on debt using 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 indicates a better ability to pay interest on debts. If you have a ratio of 6, this means your business makes enough money to earn six times the amount required to pay interest during that period. It is also an indication of operational efficiency. An increasing ratio suggests your business is becoming more efficient at generating income.

It indicates better financial health and lower risk. Lenders, creditors, and investors may use your interest coverage ratio to determine whether to do business with you.

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 a business’s ability to pay its debts. The ratio tells you how your assets compare to your liabilities. A ratio of more than 1 means you can pay your short-term liabilities. For example, if you have a ratio of 2, 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

A ratio of less than 1 may indicate you have difficulty covering short-term debt. A ratio of 2 or higher is often seen as having strong liquidity.

Cash ratio

The cash ratio assesses your ability to cover immediate debts using only cash and cash equivalents. It is 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 considered healthy. The higher the ratio, the better able you are to cover your short-term debt obligations. It means you have enough cash to cover immediate debts.

Tips to boost your liquidity

If you are concerned your liquidity is low, there are steps you can take to improve it:

• Use accounting software like Xero to improve your invoice collection. This makes sending invoices and receiving payment much easier and more efficient. The more efficient your invoice collection, the better your cash flow.
• Take charge of your accounts receivable by offering discounts or other incentives for early payments.
• Pay off your debts more quickly. Control your accounts payable by negotiating favorable payment terms with suppliers. Extend payment terms where it makes sense. Cut all non-essential or discretionary spending. Find more cost-effective suppliers if possible.
• Monitor and reduce your operating costs. Sell off unproductive assets to improve your cash reserves and cash flow. Lease or rent equipment as appropriate.
• Don’t stockpile inventory. Keep levels at industry standards and implement just-in-time inventory ordering so your cash isn’t tied up in inventory.
• Look to increase sales. Find ways to expand your customer base or introduce new products or services without increasing your operating costs.