The solvency Ratio is a tool to measure the company’s ability to commit to future payments. The solvency ratio indicates whether the company is sufficient to meet its short and long-term liabilities.
The greater the company’s solvency ratio, the lower the probability of debt obligations on it. There are two types of proportions, and they differ in their nature.
Solvency ratio formula = total income after cutting out the tax, divided by the debt obligation.
Key Takeaways
- Short-term solvency ratios assess a company’s ability to meet its short-term financial obligations, while long-term solvency ratios evaluate its ability to meet its long-term financial obligations.
- Key short-term solvency ratios include the current and quick ratios, which measure liquidity. In contrast, key long-term solvency ratios include the debt-to-equity ratio and the debt ratio, which measure financial leverage.
- A higher short-term solvency ratio indicates better liquidity, while a lower long-term solvency ratio suggests a lower level of financial risk.
Short Term vs Long Term Solvency Ratio
The difference between short-term and long-term solvency ratios is that Short term solvency ratio indicates the company’s current assets divided by the current liabilities. At the same time, Long term solvency suggests the company’s net worth divided by total debt obligation in the market.
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Both these terms are linked to a company’s economic, financial, and business status. However, we may discuss the differences between them.
Comparison Table
| Parameter of Comparison | Short term solvency | Long term solvency |
|---|---|---|
| Character | Short term solvency ratio is used to check the current financial situation of the market. | Long-term solvency checks the overall financial and economic health of the company. |
| Scheme | It includes the current assets involved and the debt or equity statements made by it. | It includes the overall assets and income from the beginning and the total debt obligations in the market. |
| Liability | The liability factor is tiny or can even be neglected. | The liability incurred by the shareholders is vast and may affect the company’s economic situation. |
| Operator time | The short-term solvency method takes less time to analyze, usually less than one month for financial analysis. | Long term solvency method takes more than one year to analyze the financial and economic situation. |
| Security | Short-term solvency is always preferred as it has less chance of cash loss. | Long-term solvency is riskier if it has vast debt; it may become unrecoverable, leading to ownership change. |
What is Short Term Solvency Ratio?
The short-term solvency ratio is used to judge the present financial situation of a company by calculating the assets recently used by the profit or loss made in the business.
It has fewer liabilities and more chances of recovering from debt loss. It can be managed efficiently by watching the current situation.
The different types of short-term solvency ratios are –
- Current ratio: It addresses the existing debt and assets of the company.
- Acid test ratio: This measures the company’s ability and how efficiently it uses its cash or asset.
- The inventory turnover ratio addresses how often the inventory is used or sold annually.
- Accounts receivable turnover indicates how efficient a company is in credit score and debt.
Advantages of short-term solvency ratio:
Financial analysis: A short-term solvency ratio is a good option, where you can understand the company’s capability in business. It uses only the current assets, and liability pressure is less.
Operating cycle: Short-term solvency ratio enhances the operation cycle of the company. It quickly converts current assets into cash. It also helps with management efficiency.
Disadvantages of short-term solvency ratio:
Inventory: Short-term solvency includes inventory in the calculation, which may lead to overestimating the debt obligations and thus give a wrong ratio result.
Standalone failure: Short-term solvency cannot withstand huge liabilities and often proceed to ownership change.
What is Long Term Solvency Ratio?
The long-term solvency ratio is the company’s total assets divided by the market’s liabilities or debt obligations.
Long-term liabilities are listed in the balance sheet as debentures, loans, tax, and pension obligations. The long-term solvency ratio may take one year or even more to cope with the current situation.
Long-term liabilities are a valuable tool for management analysis in financial ratios. This can be overcome by increasing net income, future investment, or money from new debt agreements.
The different types of long-term solvency ratios are –
- Debt Ratio: It measures the assets and debt obligation of a company.
- Equity ratio: It indicates the financial ratio of the company.
- Quick Ratio: A quick ratio is similar to an acid test ratio, but the operation period is more here.
- Cash Ratio: The ratio of income from assets and debt obligation.
Advantages of long-term solvency ratio:
Quick cash: Long-term solvency allows you to convert assets into cash quickly. This method can be applied if you want to profit in less time.
Stock exchange: The business can be grown by sharing investments with shareholders and buying stock exchanges from the market. Net income can be reinvested with proper tax management.
Disadvantages of long-term solvency ratio:
Liabilities: Long term solvency ratio method includes vast liabilities due to debt obligations. It may increase the tax rate and even impose subsidies on the company.
Operation cycle: Long-term solvency usually takes one year or more to stabilize the financial and economic error and manage the global market situation.
Main Differences Between Short-Term and Long-Term Solvency Ratios
The key differences between them are listed below:
- Short term solvency ratio is used to check the current financial situation of the market. Long-term solvency checks the overall financial and economic health of the company.
- Short-term solvency is not listed in share markets, but long-term solvency is listed in share markets to buy stock exchange.
- The operation cycle is short in short-term solvency, and the operation cycle is long in long-term solvency.
- Liability is less in short-term solvency, and liability is large in long-term solvency.
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Chara Yadav holds MBA in Finance. Her goal is to simplify finance-related topics. She has worked in finance for about 25 years. She has held multiple finance and banking classes for business schools and communities. Read more at her bio page.
