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Assessment of Liquidity and Solvency of the Company: Analysis of Balance Sheet

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Introduction

The main goal of enterprise management is to ensure the survival of the enterprise in the market and improve its well-being. An important role in the implementation of this task is given to the financial analysis of the enterprise.

Financial analysis helps to develop the strategy and tactics of improvement of the enterprise, to make management decisions, monitor, identify reserves for improving production efficiency, assess the performance of the enterprise and its divisions. One of the main criteria for financial analysis is an analysis of the liquidity and solvency of the company.

Solvency and liquidity are the main characteristics of the financial condition of the organization. These indicators ensure the survival of the company in the market.

The liquidity of the balance sheet is the ability of a company to cover its liabilities to creditors with the help of its assets. The liquidity of the balance is one of the most important financial indicators of the enterprise and directly determines the degree of solvency and the level of financial stability. The higher the liquidity of the balance, the greater the rate of repayment of debts of the enterprise. Low balance sheet liquidity is the first sign of bankruptcy.

The main purpose of this essay is to determine the role of liquidity and solvency indicators in assessing the financial condition of an organization.

The first part of this essay presents the theoretical aspects of the analysis of solvency and liquidity. The second part presents an analysis of the financial condition of the Limited Liability Company “Track Test Systems” using groups of solvency and liquidity ratios.

Theoretical aspects of the analysis of solvency and liquidity

Solvency and its impact on the company

Solvency is a company’s ability to pay its debts as they become due. A company’s solvency determines its ability to service debts and achieve long-term growth and profitability. A business that is completely insolvent is unable to pay its debts and will be forced into bankruptcy. Investors should examine all the financial statements of a company to make certain the business is solvent as well as profitable.

Solvency analysis is necessary not only for an enterprise to assess and forecast financial activities, but also for external investors (banks). Before issuing a loan, the bank must verify the creditworthiness of the borrower. The same must be done by enterprises that want to enter into economic relations with each other. It is especially important to know about the financial capabilities of the partner, if the question arises about giving him a commercial loan or deferring payment.

The main sources of information for analyzing the solvency and creditworthiness of an enterprise are the balance sheet (Form No. 1), the profit and loss statement (Form No. 2), the statement of capital movements (Form No. 3) and other forms of financial statements.

There are a number of ways to analyze a company’s solvency. One key test is to look at the solvency ratio, which measures a company’s ability to meet its debt and other obligations. It is calculated by adding net income (or after-tax profit) to depreciation and then dividing that by a company’s short-term plus long-term liabilities. The lower the solvency ratio the more likely a company will default on its debt in the future.[footnoteRef:1] [1: Official website of The Motley Fool ( is a multimedia financial services company) https://www.fool.com/]

When a company can no longer meet its financial obligation that company has become insolvent. This often leads to insolvency proceedings in which legal action is taken to liquidate a company’s assets to pay down its debt.

Liquidity and its impact on the company

It is important to note that despite the fact that the concept of liquidity and solvency are closely interrelated, they are not identical.

Liquidity ratios are an important class of financial metrics used to determine a debtor’s ability to pay off current debt obligations without raising external capital.

Liquidity describes the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset’s price.

Liquidity ratios are calculated as the ratio of assets to liabilities. There are two main financial ratios used to measure a company’s liquidity ratio.

  1. Current ratio equals current assets divided by current liabilities. This should have a target ratio of 2 to 3, which indicates you have adequate liquid funds to pay your current obligations.
  2. Quick ratio equals current assets (less inventory) divided by current liabilities. This should have a target ratio of 1 to 2, which indicates your liquid funds without selling your inventory.

Liquidity ratios are financial analysis tools commonly used to gauge a company’s ability to repay short-term creditors out of its cash fund. Liquidity ratios measure a company’s liquid assets against its short-term liabilities. In general, the more liquid assets you have to cover short-term liabilities, the more likely it is that you’ll be able to pay debts as they become due without running out of funds to support ongoing operations. Companies with low liquidity ratios have a higher risk of encountering difficulty meeting obligations. Liquidity ratios basically allow you a way to gauge your paying capacity on a short-term basis.

For a better understanding, let’s consider liquidity ratios on the example of the company STS LLC.

An analysis of the financial condition of the limited liability company “track test systems”

Description of the company

Limited liability company STS (Tracking Test Systems) is an engineering company. The main activities are development, production and application of technology systems prestressing structures in the construction of buildings and structures.

STS sees its mission in providing modern building structures with reliable and efficient technological solutions

STS carries out the development and production of materials, systems and equipment for prestressed reinforced concrete, develops design and technological solutions, regulatory and technical documentation, and also performs construction and installation work. The main strengths are:

  • “STS” is the sole Russian constructor and manufacturer of prestressing systems
  • Is a manufacturer of unique products, equipment and services
  • The scientific and technical potential of the company makes it possible to be ready to implement the most complex technical solutions in a short time.

Analysis of balance sheet liquidity on the example of LLC ‘STS»

According to the company’s balance sheet and financial statement, an analysis of the organization’s financial performance was carried out.

In this section, we analyzed the liquidity ratios of the organization in the period from 2014 to 2017. Indicator – the absolute liquidity ratio, which is of the greatest interest to the management of the company, does not correspond to standard values.

The organization has a large amount of accounts payable, compared with cash and short-term financial investments. However, as can be seen in Table 1, the positive dynamics of this indicator can be traced. If in 2014 the organization repaid 0.004% of its short-term liabilities daily, over the past 2 years the figure is in the range of 1-3%/

Table 1

The absolute liquidity ratio 2014-2017 [footnoteRef:2] [2: Compiled by the author on the basis of calculations according to the balance sheet and the report on financial results]

2015

2016

2017

standard

The absolute liquidity ratio

0.00005

0.03211

0.01256

>0.2

The quick ratio (Figure1), which is of the greatest interest for banks, corresponds to the standard values ​​(0.7-1).

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Figure 1. The quick ratio 2014-2017 [footnoteRef:3] [3: Compiled by the author on the basis of calculations according to the balance sheet and the report on financial results]

Compliance with the norm means that the company will be able to respond to its obligations if the situation becomes critical. However, it is worth noting that a large proportion of liquid funds in calculating the ratio is accounts receivable, which will be difficult to recover. Therefore, management should take measures to manage receivables and reduce their share.

The current liquidity ratio, which shows the company’s ability to repay current liabilities at the expense of current assets only, slightly below the recommended values. From Figure 2, we see that in 2014 the value was below 1, which indicates a high financial risk and suggests that the company is not able to consistently pay its current accounts. Since 2015, the company has rehabilitated – over the past 3 years, the coefficient under consideration is higher than 1.

Figure 2.The current liquidity ratio 2014-2017 [footnoteRef:4] [4: Compiled by the author on the basis of calculations according to the balance sheet and the report on financial results]

Next, we will analyze the solvency ratios.

Figure 3 presents the value of the coefficient in the period from 2014 to 2017. In 2014, a crisis situation was observed, as evidenced by the coefficients discussed above. Since 2015, there has been a positive trend. The recommended value of the indicator is 0.5-0.7. In 2017, the highest coefficient is 0.21, however, we see that, despite the positive dynamics, the values ​​do not correspond to the recommended ones. It is worth noting that in some cases, the company can maintain a stable financial position even if the solvency ratio is below 0.5.

In this case, the analyzed company:

  • marked by stable demand for products
  • has established supply and sales channels
  • in 2017, there is an increase in more than 5 times compared with 2014, asset turnover (2017 – 3.56, 2014 – 0.65) and turnover of current assets (2017 – 4.11, 2014 – 0.76)

Figure 3. Total degree of solvency of the company for 2014-2017 [footnoteRef:5] [5: Compiled by the author on the basis of calculations according to the balance sheet and the report on financial results]

Let’s analyze the indicators of financial independence of the company. The autonomy coefficient (Figure 4) does not match the recommended values ​​(more than 0.5). However, there is a positive trend.

Figure 4. Coefficient of autonomy 2014-2017 [footnoteRef:6] [6: Compiled by the author on the basis of calculations according to the balance sheet and the report on financial results]

The value of the coefficient below 0.5 means that the assets of the company are mostly formed from borrowed sources. The company is dependent on external sources of financing. Positive dynamics indicates an increase in the financial strength of the company. This coefficient can be considered together with the independence coefficient (Figure 5).

Figure 5. The independence coefficient 2014-2017[footnoteRef:7] [7: Compiled by the author on the basis of calculations according to the balance sheet and the report on financial results]

The recommended value is less than 1. In the company being analyzed, this indicator significantly exceeds the recommended value. This means that the ratio of own and borrowed sources of financing has been broken. Borrowing sources prevail in the financing of the company.

Figure 6. The coefficient of financing 2014-2017 годы[footnoteRef:8] [8: Compiled by the author on the basis of calculations according to the balance sheet and the report on financial results]

The values ​​of the coefficient of financing of the company ‘STS’ (Figure 6) indicate that borrowed funds are not covered by their own sources of funding. Recommended values ​​are greater than one. Since 2015, there has been a positive trend, and, in 2017, the company was able to cover 21% of its borrowed funds with its own capital.

Consider another factor from the group of indicators of financial independence of the company (Figure 7).

Figure 7. The concentration ratio of attracted capital [footnoteRef:9] [9: Compiled by the author on the basis of calculations according to the balance sheet and the report on financial results]

The recommended value is below 0.4. Exceeding the recommended value, as evidenced by the diagram, means that the largest share of funds invested in the company “STS” is borrowed funds.

[bookmark: _Toc6329588]Conclusions on the results of liquidity analysis and assessment of solvency of LLC ‘ STS»

Thus, by calculating the financial and economic indicators of the company on the basis of the balance sheet and the statement of financial results it can be concluded that for many indicators there is a discrepancy between the normative values.

However, this discrepancy does not mean that the company is in critical condition. According to the chief accountant, the existing standards for many indicators are too high, and sometimes unrealistic for Russian companies. The company has recently moved from small to medium-sized businesses, it is intensively increasing sales. Especially noticeable is the jump in 2017, as shown in figure 8.

Figure 8. The revenue of OOO ‘STS’ 2014-2017[footnoteRef:10] [10: Compiled by the author on the basis of calculations according to the report on financial results]

This strong growth was due to the high level of variable costs in 2017. That is, over the past year, the cost of production and services has been very high, as shown in figure 9.

Figure 9. Cost of sales of LLC ‘STS’ 2014-2017[footnoteRef:11] [11: Compiled by the author on the basis of calculations according to the report on financial results]

Gross profit (figure 10), which represents the gross revenue cleared of variable costs, was the highest in 2017 for the last 4 years (despite the high cost price).

Figure 10. Gross profit of LLC ‘STS’ 2014-2017[footnoteRef:12] [12: Compiled by the author on the basis of calculations according to the report on financial results]

The final result of the company’s activities is the net profit, the dynamics of which is shown in figure 11. Despite the high gross profit, net profit for the last 4 years in 2017 was at the lowest level.

Figure 11. Net profit of LLC ‘STS’ 2014-2017[footnoteRef:13] [13: Compiled by the author on the basis of calculations according to the report on financial results]

This can be explained by the fact that in 2017 the company had the highest volumes of management expenses and current income tax for the period under review (the dynamics is shown in figures 12).

Figure 12. Commercial and management expenses of LLC “STS”[footnoteRef:14] [14: Compiled by the author on the basis of calculations according to the report on financial results]

We can say that in 2017, the company’s net profit was at the level of the crisis year 2014. Compared to 2015, the profit decreased slightly more than 3 times. However, the decrease in net profit does not indicate a deterioration in financial and economic indicators. In terms of liquidity, profitability and solvency, the company’s activity shows positive dynamics, despite non-compliance with regulatory values.

As noted by the chief accountant, compliance with regulatory values is not their main goal. The company adheres to an aggressive financial policy and seeks to increase its market share. The company actively uses borrowed funds. Especially often resort to loans – overdrafts.

Conclusion

Analysis of the liquidity of the balance sheet is an important task of the company to maintain the normal state of assets and liabilities, as well as the ability to timely and fully settle its obligations to borrowers. The higher the liquidity of the balance sheet, the higher the solvency of the company and the lower the risk of bankruptcy. When assessing the solvency of the enterprise, it is necessary to analyze the coefficients in dynamics and in comparison with the average values for the industry. This will identify possible threats to the risk of bankruptcy.

The use of solvency and liquidity indicators plays an important role not only in the analysis, but also in the implementation of all other management functions. Planning, day-to-day management and control in financial management are aimed at maintaining the ability of the enterprise to meet its payment obligations on time and in full in such a way as to achieve the established strategic goals and operational targets in the most efficient and effective way.

In this course work were considered indicators of solvency and liquidity on the example of LLC ‘STS’. By calculating the financial and economic indicators of the company on the basis of the balance sheet and the report on the financial results, it was concluded that many indicators are inconsistent with regulatory values.

However, this discrepancy does not mean that the company is in a critical condition, as the existing standards for many indicators are too high, and sometimes unrealistic for Russian companies.

Bibliography

  1. MacKenzie I.. Student’s Book: Professional English in Use Finance. Cambridge, 2010
  2. The balance sheet and the income statement 2014-2017 OOO ‘Test Tracking system’ (form No. 1 and form No. 2)
  3. Documents and presentations provided by the chief accountant of LLC ‘ Tracking test systems»
  4. Official website OOO ‘STS’: http://www.sts-hydro.ru/
  5. Official website of The Motley Fool (a multimedia financial services company). Mode of access: https://www.fool.com/
  6. Official website FINAM. [Electronic resource.] – Mode of access: https://www.finam.ru/
  7. Official website of CBONDS financial information. [Electronic resource.] Mode of access: http://ru.cbonds.info/news
  8. Internet-project ‘Corporate management’. [Electronic resource.] Mode of access: https://www.cfin.ru/finmarket/

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Assessment of Liquidity and Solvency of the Company: Analysis of Balance Sheet. (2022, September 27). Edubirdie. Retrieved December 1, 2022, from https://edubirdie.com/examples/assessment-of-liquidity-and-solvency-of-the-company-analysis-of-balance-sheet/
“Assessment of Liquidity and Solvency of the Company: Analysis of Balance Sheet.” Edubirdie, 27 Sept. 2022, edubirdie.com/examples/assessment-of-liquidity-and-solvency-of-the-company-analysis-of-balance-sheet/
Assessment of Liquidity and Solvency of the Company: Analysis of Balance Sheet. [online]. Available at: <https://edubirdie.com/examples/assessment-of-liquidity-and-solvency-of-the-company-analysis-of-balance-sheet/> [Accessed 1 Dec. 2022].
Assessment of Liquidity and Solvency of the Company: Analysis of Balance Sheet [Internet]. Edubirdie. 2022 Sept 27 [cited 2022 Dec 1]. Available from: https://edubirdie.com/examples/assessment-of-liquidity-and-solvency-of-the-company-analysis-of-balance-sheet/
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