Explore the difference between solvency and liquidity and how can you analyse stocks using both types of ratios.
Investing in the stock market is like navigating various financial terms and ratios. If you are starting your investment journey, you might come across multiple concepts that may sound the same but are totally different.
Today, let’s look at two terms that sound similar at first glance but hold vastly different meanings. We are talking about ‘liquidity’ and ‘solvency’.
If we give it a thought, it’s true that a company with stable liquid assets can remain solvent. But that’s just common man logic. The reality is much different.
Understanding the differences between solvency and liquidity and their ratios can help you analyse a company better and make informed investment decisions. After all, you always want to ensure that the company you are investing in is solvent and has funds to fulfil its short-term obligations.
So, let’s begin.
Liquidity Ratios
Have you ever found yourself in a tight spot and needed quick cash? Just like we rely on a savings account for quick funds, companies also need easily accessible liquid assets to meet their short-term financial obligations. Hence, companies keep liquid assets in cash, marketable securities like treasury notes, shares, and fixed deposits.
To measure a company’s liquidity, we use liquidity ratios that determine whether it can meet its short-term obligations without selling off its long-term assets or taking out short-term loans. Also, we use current assets instead of total assets while calculating liquidity ratios. While total assets might seem like the logical indicator of a company’s financial health, it includes short- and long-term assets, some of which may be difficult to liquidate quickly. That’s why we focus on current assets instead.
In short, liquidity ratios offer a snapshot of a company’s short-term financial standing, giving investors a better understanding of the company’s ability to weather unexpected financial storms.
Types of Liquidity Ratios
Working Capital Ratio or Current Ratio
The current ratio tells us whether a company can meet its short-term obligation, like debt repayment instalments, payments to its vendors and creditors, day-to-day operational expenses, etc., at any given date during the year.
The formula to calculate the current ratio is dividing total current assets by total current liabilities. However, a current ratio of less than one can be alarming, indicating that the company may struggle to meet its obligations on time.
But is a current ratio of one always a good sign?
Not necessarily. The ideal current ratio varies from industry to industry, and it’s essential to consider the company’s specific business requirements.
For instance, FMCG giants maintain a current ratio close to one, as their business requirements are fulfilled based on supplier trust.
In contrast, IT giants have current ratios ranging from 1.7 to 3, as their business model heavily depends on winning orders which can be cyclical. The major short-term liability they have are their employee costs.
Acid Test Ratio
The acid test, also known as the quick ratio, provides insights into a company’s ability to meet its obligations within three months. It is calculated by dividing the sum of cash, cash equivalents, and marketable securities or short-term investments by the total current liabilities. However, the ideal quick ratio varies from sector to sector, just like the current ratio.
For example, giant FMCG players can quickly sell their produced inventory hence having a low quick ratio is less concerning for them. Moreover, there may be no inventory to deal with for companies in the service sector, resulting in the quick and current ratios being the same.
Solvency Ratios
When we talk about an individual’s financial stability, we often look at their assets and the debt they owe. Similarly, when we consider a business’ financial stability, we look at the value of its assets compared to its liabilities which are to be paid.
In the past, many companies have taken debt. Some have been able to use it to their advantage, while others have ended up drowning in it. After all, debt can be a double-edged sword.
This is where the solvency ratios come in. It helps us understand a company’s long-term financial health. It is a valuable tool for investors to assess a company’s financial stability and potential risks.
Types of Solvency Ratios
Interest Coverage Ratio
A company’s interest coverage ratio tells us how many times of interest on its outstanding loans a company can pay using its current earnings.
The formula for calculating the interest coverage ratio is dividing a company’s earnings before interest and taxes (EBIT) by its interest expense on all outstanding debts.
For example, the interest coverage ratio of Sula Vineyards is 4.19, meaning the company has Rs 4.19 for every rupee of interest payment. If we take another example, G M Breweries has an interest coverage ratio of 3,291.50. It is high because the company is debt free.
*Data as of 18th April 2023.
An interest coverage ratio of less than one is a clear warning sign for investors. Nevertheless, the interest coverage ratio can vary significantly from one industry to another. For example, capital-intensive sectors may have a low-interest coverage ratio because they take out loans to develop projects that may not generate little income after completion. Hence, these companies have a low-interest coverage ratio.
Debt to Equity Ratio
The Debt to Equity ratio compares a company’s total debt to its equity, indicating the extent to which assets are financed by debt. The formula to calculate the debt to equity ratio is dividing the company’s total liabilities by its shareholder equity.
Companies with a DE ratio of less than one are considered safer, while a DE ratio exceeding two is viewed as risky. This means the company owes two rupees in debt for every rupee of equity.
A lower DE ratio is better, but a negative DE ratio is not desirable. A negative DE ratio occurs when a company earns lower returns on equity while paying high interest on the debt. For instance, Jet Airways has a negative DE ratio of -247, indicating a precarious financial situation.
*Data as of 18th April 2023.
To conclude, solvency and liquidity ratios are essential indicators of a company’s financial health. They measure different aspects of its financial position. The solvency ratio measures a company’s ability to repay long-term debts, while the liquidity ratio measures its ability to meet its short-term obligations.
A company may be solvent but have poor cash flow or have plenty of cash but shaky long-term prospects. Therefore, it’s crucial to analyse solvency and liquidity ratios to understand a company’s financial position.
*Companies mentioned in the article are for information purposes. This is not investment advice.
Note: This article was originally written by Teji Mandi for ET Markets.
Read the article here.
