Solvency and liquidity are two of the most important financial indicators for understanding a company's financial health. Although they're often used interchangeably, they measure different things, and buyers and investors analyze them separately in any M&A deal.
In this guide, we explain exactly what each concept means, how they're calculated, their key ratios, the practical differences between them, and why they have a direct impact on the valuation of your business during a sale process.
What is solvency
Solvency measures a company's ability to meet all of its long-term financial obligations, beyond the next 12 months. In other words, it shows whether the company as a whole can cover its debts with its total assets.
A solvent company is one that has more assets than debts and could therefore settle all of its obligations if necessary by selling its assets (property, machinery, inventory, etc.). It's an indicator of the business's structural viability.
The basic formula for the solvency ratio is:
Solvency ratio = Total assets / Total liabilities
A ratio above 1.5 is considered healthy: it means the company has a reasonable margin between what it owns and what it owes. Below 1, the company is technically insolvent (more debts than assets).
What is liquidity
Liquidity measures a company's ability to meet its short-term obligations (the next 12 months) using its most liquid assets: cash, accounts receivable, short-term financial investments, etc.
A liquid company is one that can pay its suppliers, payroll, taxes, and maturing loans without having to sell non-current assets. It's an indicator of day-to-day operational viability.
The two most widely used formulas are:
Current ratio = Current assets / Current liabilities
Acid-test ratio = (Current assets − Inventory) / Current liabilities
A current ratio between 1.5 and 2 is considered optimal. Below 1, the company may have trouble paying in the short term. The acid-test ratio (which excludes inventory) is stricter: ideally, it should be close to 1.
Practical cases: 3 typical scenarios
1. A solvent company with little liquidity
A manufacturing company with valuable machinery, owned facilities, and low debt, but very tight cash and trouble making payroll on time. Its solvency ratio may be 2.5 (excellent), but its current ratio barely reaches 0.8.
M&A implication: an interested buyer may value it well for its assets (high enterprise value), but will demand adjustments to the deal: bridge financing, escrow, or earn-out clauses tied to cash generation.
2. A company with liquidity but no long-term solvency
A startup after a funding round has €5 million in cash (excellent liquidity) but burns €500,000 a month and doesn't yet generate positive EBITDA. Its current ratio may be above 5, but its solvency depends entirely on future funding rounds.
M&A implication: buyers will apply multiples to revenue or projections (not to EBITDA) and will require concrete viability plans. The valuation will be much more volatile.
3. A company with good solvency and liquidity
The ideal scenario: a company with a solvency ratio of 2 and a current ratio of 1.8. Balanced accounts, enough cash to operate, manageable debt, and consistent operating margins.
M&A implication: these companies are the most sought after by strategic buyers and private equity firms. They command higher multiples and faster deals, with fewer restrictive clauses.
Why they matter in an M&A deal
Solvency and liquidity are two of the pillars of financial due diligence. Buyers analyze them separately to understand:
- Short-term default risk: will the company be able to pay its suppliers and employees during the transition period after closing?
- Structural stability: will the company be able to service its long-term debt without viability problems?
- Capital needs: will the buyer have to inject additional capital after the deal?
- Working capital: is the current working capital sufficient, or does it need adjustments?
Findings in these areas can translate into price adjustments, additional warranty clauses, or changes to the deal structure. That's why getting these ratios in good shape before starting a sale process is one of the most effective levers for maximizing the value of your business.
If you want to better understand how your company's ability to generate cash is valued, we recommend our guide to free cash flow.
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Frequently asked questions about solvency and liquidity
Can a company be solvent and illiquid at the same time?
Yes, and it's one of the most common scenarios in manufacturing companies or businesses with many physical assets. A company with valuable machinery but trouble collecting from customers can be solvent (large total assets) but illiquid (little available cash). This calls for short-term financial solutions even when structural viability is assured.
Which ratio matters more to an investor?
It depends on the investment horizon. A fund with a 5–7 year horizon will prioritize solvency (will the company be viable in the long term?). A strategic buyer looking for immediate cash generation will prioritize liquidity (will the company be able to pay and operate without financial stress from day one?).
How can these ratios be improved before selling a business?
To improve liquidity: reduce days sales outstanding, renegotiate payment terms with suppliers, sell obsolete inventory, and optimize working capital. To improve solvency: pay down debt, capitalize reserves, and avoid new long-term liabilities. These adjustments can be made in the 6–12 months before starting a sale process.
How do they relate to EBITDA?
They're complementary indicators. EBITDA measures operating profitability (the ability to generate profit). Solvency and liquidity measure ability to pay (the ability to meet obligations). A company with good EBITDA but poor liquidity can have serious operational problems; one with good liquidity but low EBITDA may not be sustainable in the long term.
