Understanding liquidity and solvency – what investors need to know

One of the most important things to consider when looking at a company to invest in, is its ability to meet short- and long-term obligations. Whether that’s money owed to suppliers, or interest payments on debt that’s been issued to raise cash. Paying in full and on time is vitally important if a company wants to survive. If the company defaults on these payments, shareholders could suffer a total loss of their investment.

This article isn't personal advice. If you're not sure what’s right for you, seek advice. Investments can fall and rise in value, so you could get back less than you invest.

What’s the difference between liquidity and solvency?

As an investor, there are a few different tools available to assess both liquidity and solvency. But before we dive into those, let’s quickly recap the difference between the two.

Liquidity – the ability to meet short-term obligations, like money owed to suppliers.

Solvency – the ability to meet long-term obligations, like longer-term debt payments.

It’s important when analysing a company to think about both. It’s all well and good looking robust over the long term. But if a company can’t pay its suppliers, it will run into trouble in the here and now.

As always, when looking at analysis ratios it’s important to make sure you consider the broader context. There are some basic cut-off points, when you’ll need to dig a bit deeper and those will be flagged below. But more broadly, ratios should be used to compare against either other companies in the same sector or to analyse one company over time.

Liquidity ratios

When looking at short-term financial strength, which is what liquidity ratios are doing, you’ll need to look at the ‘current’ portion of a company’s assets and liabilities – found in the balance sheet.

As a recap, assets and liabilities can be split into ‘current’ (short term) and ‘non-current’ (long term).

One of the most common liquidity ratios is the current ratio, which considers everything that falls into current assets and liabilities.

Current Ratio = Current Assets / Current Liabilities

A current ratio under 1 suggests that if the company was to sell all its short-term assets, that wouldn’t release enough cash to cover its short-term liabilities. That could be a sign of danger and would warrant further investigation.

The quick ratio looks at a company’s ability to pay its short-term liabilities if inventory is not taken into account. Inventory is considered a current asset, so is included in the current ratio. But is inventory always able to be sold into cash? Perhaps not. That’s where the quick ratio comes in.

Quick Ratio = Current Assets – Inventory / Current Liabilities

A ratio well below 1 would warrant some digging. It’s also useful to compare the two ratios and if there’s a big difference, have a think about what’s included in inventory and whether it could be sold quickly if needed.

Let’s apply these ratios to real world examples, looking at the housebuilder sector.

Housebuilder current ratios

Source: Refinitiv Eikon DataStreamer, 09/09/22.

Looking at current ratios, there’s an increasing trend across the board. It’s not surprising either, the UK housing market has seen record levels of house prices and housebuilders have been reaping the rewards. That’s allowed them to keep cash on the books and boost inventory levels.

That’s positive news for liquidity and all four businesses here can comfortably cover their current liabilities with current assets. Of course, there’s no guarantee that will continue and it’s just a snapshot at a given point.

Now let’s look at the quick ratio and see if inventories have a big impact.

Housebuilder quick ratios

Source: Refinitiv Eikon DataStreamer, 09/09/22.

Interestingly, while the overall trend is an upwards one like the current ratio, the values are significantly lower. That suggests large portions of these companies’ current assets are tied up in inventory.

This highlights the importance of using more than one ratio. Looking at the two, it’s quickly apparent that understanding what’s included in inventory for a housebuilder is important. Housebuilders include land in inventory, which helps explain why it makes up a significant portion of current assets.

So, what does this tell us here?

Looking at these ratios, the housebuilders in question all look to have adequate liquidity. But it’s clear just how important the quick ratio is when analysing housebuilder liquidity given the large impact inventory has – that’s because not all inventory can be quickly turned into cash.

Please note, these ratios can and will change with time and market cycles. There’s no guarantee liquidity will remain adequate.

Solvency ratios

The ability to pay off long-term debt is essential for any company that wants a future. It’s crucial to know what to look for to gauge long-term financial stability, and solvency ratios are one tool for doing just that.

A good starting point is to look at a company’s debt to equity ratio. This looks at the proportion of a company’s funding that comes from debt versus investment from shareholders.

Debt to Equity = Total Debt / Total Equity

Both figures can be found on a company’s balance sheet and in this example total debt includes any interest-bearing liability. A ratio of 1 would imply the company is financed equally with debt and equity. Anything above one and the company is using more debt.

Typically, the higher the value the more solvency risk exists. Though, different industries will tend to use varying levels of debt. Remember, unlike equity financing, debt must be repaid at certain times and requires the payment of interest.

The second solvency ratio worth looking at is the interest cover. This looks at how a company’s profit, before interest and tax, covers its interest obligations.

Interest Cover = Earnings Before Interest and Tax (EBIT or Operating Profit) / Interest Expense

These are all figures you can find on the company’s income statement.

A ratio under 1 should be a red flag. What that’d suggest is that the business doesn’t generate enough profit to pay what it owes to its debtors (interest payments to those who’ve lent it money). A clear sign there could be trouble ahead.

As before, let’s put these into practice. This time looking at JD Wetherspoon.

Wetherspoon debt analysis

Source: Refinitiv Eikon, 09/09/22.

Relatively speaking, the debt to equity ratio looks fairly stable for Wetherspoon over the past five years. There was a slow decline from 2017-19 and an uptick again from 2020 on. Thinking about what’s happened, it’s easy to see why.

The pandemic hit the pub sector hard, and Wetherspoon had to raise cash to keep the lights on. They went to both debt and equity markets to do this, issuing both new debt and new shares. They raised slightly more from debt markets, which is why the debt to equity ratio has risen.

The next step would be to compare with peers in the industry to see if a ratio in the 2.5-3.5 range is normal.

We’ll stick with Wetherspoon, though, and see how interest cover looks.

Wetherspoon interest cover

Source: Refinitiv Eikon, 09/09/22.

This is another perfect example of why looking at more than one ratio is important. You might have thought the stable debt to equity ratio meant all was well. You’d be wrong.

Looking at the interest cover, the full impact of the pandemic and additional debt the group took on becomes clear.

Remember, profits aren’t always positive, so you can have negative interest cover. In the case of Wetherspoon, operating profit (EBIT) turned negative in the second half of 2020, only coming back to positive territory in the first half of 2022.

In examples like this, the question is whether negative interest cover is just a blip or a fundamental issue.

Not everyone has time to dig into company accounts and put different ratios together. Our Equity Research team does, and we use a whole host of analysis tools when looking at companies and putting our research together. We cover hundreds of stocks from the FTSE 350 and further afield, as well as broader pieces like sector updates and hot topics.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. Investments rise and fall in value so investors could make a loss.

This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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