Solvency vs Liquidity: Key Factors in the Financial Analysis of Companies for M&A

Solvency vs Liquidity: Key Differences in the Financial Analysis of a Company in M&A

One of the critical aspects in any merger or acquisition (M&A) process is the financial health of the companies involved. Before closing a deal, both buyers and sellers need an accurate understanding of the company’s economic situation, which requires clearly distinguishing between solvency and liquidity.

A company may appear profitable in the short term but have serious long-term financial issues. The opposite can also happen. This is why it is essential to differentiate between these two metrics, which must be included in the financial due diligence and directly impact both the company’s valuation and the agreement between the parties to finalize the deal.

What is solvency?

Solvency measures a company’s ability to meet its long-term financial obligations — that is, beyond the next 12 months. It is a structural indicator that analyses the business’s stability and strength over time.

Key ratios to assess solvency:

Debt ratio: compares total debt to equity to determine the degree of dependence on external financing.
Equity: the difference between assets and liabilities; when positive, it indicates that the company is solid and faces a lower risk of future insolvency.
Capacity to generate resources: shows whether the business generates enough operating profit to cover long-term expenses and debts.

A solvent company can overcome temporary difficulties without jeopardizing its future, which makes it more attractive in an M&A process.

What is liquidity?

In contrast, liquidity focuses on the short term: it indicates the company’s ability to meet immediate payments, such as salaries, suppliers, or taxes, over the next 12 months.

Key liquidity indicators:

Acid-test ratio (quick ratio): relates available cash to current liabilities to show how many obligations can be covered with the cash on hand.
Current ratio: divides current assets by current liabilities; it shows the ability to pay debts with assets that can be easily converted into cash.
Working capital: the difference between current assets and current liabilities, indicating the safety margin for day-to-day operations.

Adequate liquidity ensures the normal functioning of the business and prevents cash flow tensions that could affect operations.

Practical examples: why it is important to distinguish between solvency and liquidity

Although they may seem related, solvency and liquidity do not always go hand in hand. A company can be highly solvent but have liquidity problems, or vice versa.

Highly solvent company with liquidity problems

This is common in industrial or real estate sectors, where there are many fixed assets. Imagine a cement manufacturer with its own facilities, machinery, and low long-term debt. It is a solvent company. However, if the construction market slows down and two of its five main clients cancel orders, it may run out of liquidity to pay suppliers or salaries despite its structural strength.

Liquid company with low solvency

A startup after a funding round may have plenty of cash and excellent liquidity ratios. However, if its business model requires constant capital injections and it does not yet generate sufficient profits, it will not be solvent in the long term. This is common in tech or high-growth businesses, where initial cash does not guarantee future viability.

Impact on valuation and the M&A deal

A combination of good solvency and liquidity increases buyer and investor confidence, raises the company’s valuation, and facilitates the closing of the deal. Conversely, imbalances in either area will require more exhaustive financial due diligence to identify risks, which may lead to price adjustments or changes in the deal’s conditions.

For example:

A solvent company without liquidity may need bridge financing or additional guarantees.
A liquid company with low solvency will require strategies to ensure its long-term sustainability.

The impact will always depend on the type of business, the origin of the imbalance, and its severity.