The Comprehensive Guide on How to Read a Financial Report: Wringing Vital Signs Out of the Numbers, + Website

CHAPTER 3

MASTERING THE BALANCE SHEET

Solvency versus Liquidity

Before we delve into the basic attributes, structure, and format of a typical company balance sheet, a discussion needs to be held on the topic of solvency versus liquidity. The reason for this is simple, as if one looks at the financial condition of “Western” governments (e.g., the United States, Japan, and most of Europe), you read that most if not all of these countries are technically insolvent, yet all seem to have ample liquidity (or availability to cash to cover ongoing costs and expenses) to support continued government functions. But of course wouldn’t you know it, just as we were completing this book, the U.S. government “shutdown” in October of 2013 as a result of not being able to sell new debt to raise cash to continue normal operations. So now we have a situation where the U.S. government is both illiquid and insolvent.

The concepts of liquidity and solvency apply not just to governments but to a number of businesses as well including financial institutions such as banks, insurance companies, auto manufacturing businesses, and others (again, types of entities singled out for being insolvent at one point or another over the past five years).

The key when reviewing the definitions is to understand liquidity versus solvency from an accounting or business perspective and realize this critical concept. Being solvent ≠ being liquid and conversely, being liquid ≠ being solvent.

To better illustrate this point, ...