Solvency, liquidity and profitability are concepts that are heard every day within companies,and that are fundamental when it comes to knowing the economic situation that is being experienced at a given time. So far so clear, but do they mean the same thing?
Although it is true that solvency, liquidity and profitability are concepts that usually go hand in hand, the reality is that they do not mean the same thing. In fact, it is important to know the differences between each one, to avoid committing a wrong decision, which may negatively affect the financial health of your business.
Aware of its importance, through this post we will tell you the differences between solvency, liquidity and profitability.
What does ‘solvency’ mean?
When we talk about solvency,we are referring to the ability that a company has to be able to face outstanding debts, through its assets,or what is the same, its cash, current accounts, collection rights, real estate, machinery, etc. That said, it is also important to differentiate between short-term and long-term solvency.
Short-term solvency provides a guarantee to a company that it will be able to pay outstanding debts in a short period of time. On the other hand there is long-term solvency, which means that a company has the fixed assets and the necessary resources, as to be able to generate the amount of money necessary to pay the possible debts that appear from a year onwards.
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To know the solvency of a company, it is possible to divide the total value of the assets, by the value of the liabilities, which are the outstanding debts and payment obligations, excluding the Net Worth of the operation.
What does ‘liquidity’ mean?
Liquidity is the ability of a company’s assets to be converted into money in the short term. That is, if solvency is based on assets, liquidity is focused on income from cash or banks, credits to customers for the sale of products, stocks of products and materials, etc.
When calculating liquidity, we must exclude those assets that are part of the fixed asset, such as real estate, real estate, machinery, etc.
What does ‘profitability’ mean?
Profitability refers to the ability of a company to generate profits and make a profit after making an investment.
Here we must differentiate between the different types of profitability that exist:
- Economic profitability: this is the direct return that is obtained through the investments of the company, or what is the same, the profit obtained, compared to the resources used to obtain these benefits.
- Financial return: return offered by an investment, compared to the total resources used.
- Social profitability: it is the profitability that both public and private companies, as well as the NGO, seek.
- Negative return– when the interest rates on a deposit or credit are below zero.
What is the relationship between solvency, liquidity and profitability?
As we have said before, the concepts of solvency, liquidity and profitability are closely related to each other, and all three directly affect the economy of a company. Below we will explain that relationship.
The first thing to keep in mind is that in order for a company to carry out an efficient management of the treasury, the most important thing is that it has the capacity to guarantee the payment of all the expenses that have generated. Once the payment is guaranteed, the next thing is to have enough balance to be able to face possible economic unforeseen events.
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Having said that, these economic resources do not need to be cash. In fact, it is very common for companies, with the aim of obtaining profitability, to invest short-term assets.
It must also be made clear that just because a company has liquidity, it does not mean that it is solvent,since it is possible for a company to have the capacity to deal with short-term debts, but not long-term debts.
Finally, in order to have solvency in the short term, the only thing necessary is to have cash in cash,while in order to guarantee the solvency of a company in the long term, it is essential to generate profits.
In short, the concepts of solvency, liquidity and profitability,although closely linked, and have a great importance in the economic stability of a company, do not mean the same thing.
All three are necessary to ensure the proper functioning of a company in the long term, and therefore in AYCE Laborytax we put at your disposal our team of accounting advice,composed of professionals with extensive experience in the management of both the treasury and the assets of a company, who will help you to make profitable the investments of your fixed assets in the medium and long term.