Solvency Ratio is a tool to measure the company’s ability to commit for 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 is the probability of debt obligations on it. There are two types of ratios and they differ in their nature.
Solvency ratio formula = total income after cutting out the tax, divided by the debt obligation.
Short Term vs Long Term Solvency Ratio
The main difference between short term and long term solvency ratio is that Short term solvency ratio indicates the company’s current assets divided by the current liabilities. Whereas Long term solvency indicates the company’s net worth divided by total debt obligation in the market.
Both these terms are linked to the economical, financial, and business status of a company. Though we may discuss the differences between them.
Comparison Table Between Short Term and Long Term Solvency Ratio (in Tabular Form)
| 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 economical 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 very small or can even be neglected. | The liability incurred on the shareholders huge and may affect the economic situation of the company. |
| Operator time | 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 most preferred as it has less chance of cash loss. | Long term solvency is riskier if it has huge debt it may become unrecoverable and lead to ownership change. |
What is Short Term Solvency Ratio?
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 watching at the current situation.
The different types of short term solvency ratio are –
- Current ratio: It addresses the current debt and asset of the company.
- Acid test ratio: This measures the ability of the company, how efficiently it uses its cash or asset.
- Inventory turnover ratio: It addresses how many times the inventory is used or sold in a year.
- Accounts receivable turnover: It indicates how efficient is a company in credit score and debt.
Advantages of short term solvency ratio:
Financial analysis: Short term solvency ratio is a good option, where you can understand the capability of the company 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 overestimation of the debt obligations and thus giving a wrong ratio result.
Standalone failure: Short term solvency cannot withstand with huge liabilities and often proceed to ownership change.
What is Long Term Solvency Ratio?
Long term solvency ratio is the total asset of the company divided by the total liabilities or debt obligations in the market.
Long term liabilities are listed in the balance sheet, debentures, loans, tax, and pension obligations. Long term solvency ratio may take one year or even more cope up with the current situation.
Long term liabilities are a useful tool for management analysis in the 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 ratio 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 acid test ratio but here the operation period is more.
- Cash Ratio: It is the ratio of income from assets and debt obligation.
Advantages of long term solvency ratio:
Quick cash: Long term solvency gives you the chance to quickly convert the assets into cash. 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.
The short term is better to start a new business as it has fewer shareholders and liability pressure with no tax.
Long term solvency ratio is for large business companies with efficient directors and employees to handle tax, share, and debt obligations.
Thus now you have a clear concept of these two financial terms. Choose wisely!
References
- https://papers.ssrn.com/sol3/papers.cfm?abstract_id=375880
- https://www.jstor.org/stable/2490168