Transcription Doc

Introduction to Solvency and Liquidity

Note: This transcription document is a text version of the upGrad videos present in this session.
It is not meant to be read independently but can be used to complement your video watching
experience.

Video 1

Speaker: Kane Hooper

In business, solvency is very important from a legal perspective. Most companies enact laws that set
specific guidelines with heavy penalties for board members and CEOs who continue to run their
businesses while they are insolvent.

As an executive you must have a very clear understanding of solvency. And you should know how
to use the appropriate tools to ensure you maintain solvency within your organisation. So, what
exactly does the term mean?

Solvency is a measure of the long-term financial health of a company. In accounting terms, solvency
is defined as ‘the ability of a company to meet its long-term debts and financial obligations.’

The term comes from Latin, solvēns which means ‘to free’. In this context it is the ability of an
organisation to free itself from its obligations and debt. While viability is a short-term measure of the
company’s ability to survive, solvency demonstrates a company’s ability to manage its operations
into the future.

Most companies accumulate debt as part of their operation. Some of this is short-term debt such as
utility bills or short-term finance from banks such as lines of credit. Long-term debt is used by many
companies to help them expand their operations, implement new product lines, purchase equipment
etc.

A very quick way to assess the long-term solvency of an organisation is to compare the assets of the
organisation with the liabilities.

Solvency: Assets - Liabilities

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While there are certainly other factors to assessing solvency, this is a very quick way to make an
assessment of a company’s solvency. A quick review of Apple’s 2019 balance sheet will give us an
idea of the company’s solvency.

Apple’s total assets for 2019 were reported at USD322 billion, while its total liabilities were reported
at USD225 billion. This quick method of assessing the solvency (assets minus liabilities) gives us a
value USD97 billion which is a positive number.

The idea of solvency in this manner is that Apple has sufficient assets to cover all of its obligations.
If need be, Apple could sell off its assets and pay down its liabilities.

There are limitation of this method of assessing solvency though. For example, a company may have
more assets than liabilities, but these may be in the form of machinery, plants and land. In such a
scenario, it would not be a good option to sell the company’s assets to cover their debts.

Nevertheless, for assessing a business, comparing assets and liabilities is a quick way to review
solvency at a macroscopic level.

Moving on we will discuss liquidity, a more accurate measure of the survival potential of the
company. Liquidity can provide greater insight into a business’ ability to cover its short-term
obligations.

But before that let’s take a look at some examples of solvency.

Video 2

Speaker: Vikram Kulkarni

Infosys is one of the major players in the Indian IT space. Infosys generates revenue from providing
IT products and services to various clients internationally.

If you look at the Balance Sheet of Infosys (image shown below) then you will notice that total Assets
are worth Rs. 92,768 Crores (long term assets + short term assets)

Whereas if you look at the liabilities part of it then it is just Rs. 26,924 Crores (Non-Current or Long-
Term Liabilities of Rs. 6,068 Crores and Current or Short-Term Liabilities of Rs. 20,856 Crores)

This means from the solvency perspective which is if we subtract Total Liabilities from Total Assets
then we will get a surplus.

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 • Total Assets – Total Liabilities

• Rs. 92,768 Cr. – Rs. 26,924 Cr.

• Surplus of Rs. 65,844 Cr.

This shows that the company Infosys is very much solvent and healthy with respect to paying off all
sorts of Liabilities.

Video 3

Speaker: Kane Hooper

Earlier we looked at some examples of companies to see whether they were solvent or insolvent.
We saw how Lehman Brothers had made poor strategic decisions resulting in an inability to meet its
short-term liabilities.

The ability of a company to meet its short-term debts is known as liquidity.

While a company may be solvent, it may have low liquidity and be unable to continue its operations.
It is important for the survival of a company that it achieves both liquidity and solvency.

In accounting, a liquid asset is defined as an asset that is either cash or can be converted into cash
very quickly. Examples of liquid assets include:
● Physical cash on hand
● Cash in bank accounts
● Accounts receivable (the money owed to you from your customers)
● Stocks (Shares owned by the company)

For a business to survive and be successful it must have sufficient liquid assets to cover its short-
term liabilities. Examples of short-term liabilities include:
● Invoices owed for inventory
● Invoices owed for utilities and other services
● Taxes payable
● Short-term debt (such as lines of credit)

As with solvency, there is a very simple method of determining the liquidity of a company. This is to
compare the current assets with the current liabilities. This however is a simplified method of
determining liquidity and has some limitations which we will discuss later.

Let’s take a look at some examples of liquidity.

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 Video 4

Speaker: Vikram Kulkarni

In order to assess the health of a company, viability and solvency are two critical parameters. Viability
is the first critical factor we assess when we evaluate a company. By this parameter, we analyse
whether the company is able to make consistent profit year on year or not. If a company is
consistently making a profit every year, then the product is viable, and the company is generating
money from their business. If a company is incurring losses, then it is burning money. Such a company
is not manageable in a longer run. Let us analyse the financials of Infosys to see its viability &
solvency. As seen from the graph, Infosys is making a consistent profit year-on-year. The profits have
increased ~23% from 2016 to 2020. This proves that Infosys is viable year on year.

The second critical factor of analysis is solvency. To assess the solvency of a firm, a quick method is
to calculate the difference between the total assets and total liabilities. A positive value of the
difference indicates that the company is capable enough to manage all liabilities through all assets
and no other external funding is required to pay off the liabilities. When we analyse the financials of
Infosys to assess their solvency, we find that the company has surplus over the time period of 2016
to 2020. The surplus of Total Assets over the Total liabilities has increased ~6.5% from 2016 to 2020.
So, from the above two graphs, it is clearly visible that Infosys is not only viable but is solvent at the
same time as well.

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