The decision by investors to invest or not to invest in a company is mainly determined by two factors – liquidity and solvency.
Liquidity is when the company does not have enough cash to pay for its immediate debts. A company that is solvent can typically acquire cash to resolve this liquidity issue by getting a loan against assets or issuing stock. The two are beneficial to the investor because they help investors to examine the financial health and position carefully.
Liquidity measures credit worthiness in the short term (less than 12 months).
When the company has enough money to pay its creditors, it is liquid. When the cash is not enough, it is illiquid. A company is said to be solvent when its assets exceeds its liabilities. When liabilities exceed assets, it is insolvent.
Solvency measures credit worthiness in the mid and long-term (longer than 12 months).
It asks the question – How many months can the company meets its obligations before cash runs out? How quick can the non-current assets be converted into cash?
Can the assets be sold successfully before the cash burns out?
• Credit worthiness refers to the firm’s ability to pay its debts on time.
• Assets are what the company can use to pay for goods and services. Assets may be cash, inventory, property or other financial instruments. Companies use asset to pay for its obligations.
• When a company’s assets are greater than its liabilities, it is solvent. In other words, if it were required to pay up right now, it would have enough assets to pay them off.
A company can have liquidity and still be insolvent. This occurs if a company has enough cash to meet its near-term debts, but all of its assets are less than the total amount of money owed. A company can sometimes resolve insolvency, particularly if it has liquidity. To do so, the company reduces expenses to increase cash flow to eventually have more assets than debts, or the company reduces debts, which may include negotiating with the debt holders to reduce the total amount owed.