Reading Financial Reports for Profitability Ratios
How Investors Determine the Book Value per Share
How Financial Report Readers Can Detect Problems in Overstated Assets

Solvency and Liquidity

Solvency and liquidity both measure the ability of an entity to pay its debts. Solvency has a long-term focus, while liquidity addresses short-term payments. Solvency refers to the ability of a business to pay its liabilities on time. Solvency measures whether or not a company is viable — a business that can generate sufficient cash flow to operate over the long-term (multiple years).

Liquidity, on the other hand, refers to the ability of a business to keep its cash balance and cash flows at adequate levels so that operations aren’t disrupted by cash shortfalls. When considering liquidity, the focus is on the next six months or the next year.

Understanding the risks of late payments

Delays in paying liabilities on time can cause serious problems for a business. Customers may shy away from doing business with a company that has financial problems. Vendors may not be willing to sell the company product because of the risk of not being paid. Customers and vendors may hear about a company’s financial issues through media reports (newspaper, TV, web).

In extreme cases, a business can be thrown into involuntary bankruptcy. In a bankruptcy, a court-appointed trustee may take substantial control over the business and its decisions about debt payment. Even the threat of bankruptcy can cause serious disruptions in the normal operations of a business.

Recognizing current assets and liabilities

Short-term, or current, assets include:

  • Cash

  • Marketable securities that can be immediately converted into cash

  • Assets expected to be converted into cash within one year

The operating cycle is the process of converting current assets (largely inventory and accounts receivable) into cash. The term operating cycle refers to the repetitive process of putting cash into inventory, holding products in inventory until they’re sold, selling products on credit (which generates accounts receivable), and collecting the receivables in cash.

In other words, the operating cycle is the “from cash — through inventory and accounts receivable — back to cash” sequence. The operating cycles of businesses vary from a few weeks to several months, depending on how long inventory is held before being sold and how long it takes to collect cash from sales made on credit.

Short-term, or current, liabilities include non-interest-bearing liabilities that arise from the operating (sales and expense) activities of the business. A typical business keeps many accounts for these liabilities — a separate account for each vendor, for instance.

In an external balance sheet you usually find only three or four operating liabilities. It’s assumed that the reader knows that these operating liabilities don’t bear interest (unless the liability is seriously overdue and the creditor has started charging interest because of the delay in paying the liability).

The balance sheet example discloses three operating liabilities: accounts payable, accrued expenses payable, and income tax payable. The terminology for these short-term operating liabilities varies from business to business.

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In addition to operating liabilities, interest-bearing notes payable that have maturity dates one year or less from the balance sheet date are included in the current liabilities section. The current liabilities section may also include certain other liabilities that must be paid in the short run (which are too varied and technical to discuss here).

Notice the following points (dollar amounts refer to year-end 2015):

  • The first four asset accounts (cash, accounts receivable, inventory, and prepaid expenses) are added to give the $8,815,000 subtotal for current assets.

  • The first four liability accounts (accounts payable, accrued expenses payable, income tax payable, and short-term notes payable) are added to give the $4.03 million subtotal for current liabilities.

  • The total interest-bearing debt of the business is separated between $2.25 million in short-term notes payable (those due in one year or sooner) and $4 million in long-term notes payable (those due after one year).

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