Entrepreneurship

Ratios for Business Decision-Making: Part 3 – Liquidity and Solvency

Javier Feliú

Javier Feliú

— 3 min read

In our earlier posts, we explored profitability ratios like Net Profit Margin, Asset Turnover, Equity Multiplier, ROA, and ROE to see how effectively a company generates profits and uses its resources. Now, it’s time to shift gears and look at Liquidity and Solvency, two critical dimensions of an organization’s financial health.

While profitability tells us how well a company generates earnings, liquidity and solvency help us understand its ability to meet short-term and long-term financial obligations. These metrics become even more important when a company relies not just on equity but also on credit (both short-term and long-term).

Liquidity: The Current Ratio

Liquidity reflects the organization’s ability to meet its short-term obligations—those due within one year or the company’s operating cycle. For organizations that rely on “day-to-day” operations for survival, this is a crucial metric.

Formula

$$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$$

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A Current Ratio > 1 indicates that the company can cover its short-term financial obligations, which is a sign of strong liquidity.

NVIDIA Example

Consolidated Balance Sheet
  • Fiscal Year Ended January 29, 2023
    • Current Assets: $23,073 million
    • Current Liabilities: $6,563 million
    • $$\text{Current Ratio} = \dfrac{23{,}073}{6{,}653} \approx 3.51$$
    • With a Current Ratio of 3.51, NVIDIA was in a very healthy position to meet its short-term obligations in 2023.
  • Fiscal Year Ended January 28, 2024
  • Current Assets: $44,345 million
  • Current Liabilities: $10,631 million
  • $$\text{Current Ratio} = \dfrac{44{,}345}{10{,}631} \approx 4.2$$
  • With a Current Ratio of 4.2, NVIDIA’s liquidity improved even further, showing they are in an extremely strong position to handle short-term financial needs.

Key Takeaways on Liquidity

NVIDIA’s high and improving Current Ratio demonstrates robust liquidity, ensuring the company can easily meet its short-term financial obligations. This is a strong indicator of financial stability, especially in industries where quick access to cash is critical for operations or responding to market opportunities.

Solvency: Liabilities-to-Equity Ratio

Solvency reflects an organization’s ability to meet its long-term obligations, which include both current and long-term liabilities. For stakeholders like banks, employees (pensions), and customers (warranties), solvency provides confidence in the organization’s sustainability over time.

Formula

$$\text{Solvency} = \frac{\text{Total Liabilities}}{\text{Equity}}$$

For a non profit, the equivalent will be:

$$\text{Solvency} = \frac{\text{Total Liabilities}}{\text{Net Assets}}$$

This ratio tells us how many dollars of obligation the company has for every dollar of equity. Lower solvency ratios indicate better financial health and lower risk.

NVIDIA Example

  • Fiscal Year Ended January 29, 2023
    • Total Liabilities: $19,081 million
    • Equity: $22,101 million
    • $$\text{Solvency} = \dfrac{19{,}081}{22{,}101} \approx 0.86$$
    • NVIDIA had 86 cents of obligation for every dollar of equity, which is a manageable level of long-term risk.
  • Fiscal Year Ended January 28, 2024
    • Total Liabilities: $22,750 million
    • Equity: $42,978 million
    • $$\text{Solvency} = \dfrac{22{,}750}{42{,}978} \approx 0.52$$
    • NVIDIA had 52 cents of obligation for every dollar of equity, a significant improvement from 2023.

Key Takeaways on Solvency

NVIDIA’s lower solvency ratio in 2024 highlights a stronger long-term financial position. The company has reduced its reliance on liabilities relative to equity, which reduces financial risk. This indicates healthy growth in equity, likely fueled by retained earnings and a strong profitability year.

What Do We Make of This Data So Far?

Answering Earlier Questions:

  1. How does this tie into ROE and ROA?
    NVIDIA’s profitability ratios (like ROA) showed remarkable improvement, but liquidity and solvency provide context for how well the company manages its obligations alongside that growth. With high liquidity and low solvency risk, NVIDIA is balancing its short-term and long-term financial commitments while delivering strong returns.
  2. What about sustainability?
    The improved solvency ratio (from 0.86 to 0.52) suggests that NVIDIA’s growth is sustainable, as it’s not overly reliant on debt. The high liquidity ratio reinforces this, showing they have the resources to handle near-term needs without financial strain.
  3. How does this position NVIDIA for the future?
    NVIDIA’s financial health gives it significant flexibility to pursue opportunities (e.g., R&D, acquisitions, or expansions) or weather challenges. Their strong liquidity ensures they can respond quickly to operational demands, while their reduced solvency risk makes them more resilient in the face of long-term uncertainties.

Looking Ahead

Liquidity and solvency ratios highlight how well a company manages its financial obligations, both short-term and long-term. For NVIDIA, the data reveals a company that is not only profitable but also financially stable and flexible.

Until next time,
J

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