What is Solvency?
Solvency is the ability of a company to meet its long-term financial obligations. When analysts wish to know more about the solvency of a company, they look at the total value of its assets compared to the total liabilities held.
An organization is considered solvent when its current assets exceed current liabilities. It is also known as the current ratio. A company is considered solvent if its current ratio is greater than 1:1.
A solvent company is able to achieve its goals of long-term growth and expansion while meeting its financial obligations. In its simplest form, solvency measures if a company is able to pay off its debts in the long term.
Liquidity vs. Solvency
Solvency and liquidity are two ways to measure the financial health of a company, but the two concepts are distinct from each other.
Liquidity refers to the ability of a company to pay off its short-term debts; that is if the current liabilities can be paid with the current assets on hand. It also measures how fast a company is able to covert its current assets to cash.
Solvency, on the other hand, is the ability of the firm to meet long-term obligations and continue to run its current operations long into the future. A company can be highly solvent but with low liquidity and vice versa. However, in order to stay competitive in the business environment, it is important for a company to be both liquid and solvent.
Assessing the Solvency of a Business
The solvency of a business is assessed by looking at its balance sheet and cash flow.
The balance sheet of the company provides a summary of all the assets and liabilities held. A company is considered solvent if the realizable value of its assets is greater than its liabilities. It is insolvent if the realizable value is lower than the total amount of liabilities.
The cash flow statement also provides a good indication of solvency as it focuses on the business’ ability to meet its short-term obligations and demands. It analyzes the company’s ability to pay its debts when they fall due while having cash readily available to cover the obligations. That is, the firm needs to be able to convert its realizable assets into cash.
The cash flow also offers insight into the company’s history of paying debt; it shows if there is a lot of debt outstanding or if payments are made regularly to reduce the liability. The cash flow statement measures not only the ability of a company to pay its debt payable on the relevant date but also its ability to meet debts that fall in the near future.
A solvency analysis can help raise any red flags that indicate insolvency. It can include a history of financial losses, the inability to raise proper funding, bad company management or non-payment of fees and taxes.
In addition to solvency ratio and liquidity ratio, other ratios can help assess the solvency of a business, including:
1. Current debts to inventory ratio
The ability of a company to rely on current inventory to meet debt obligations.
2. Current debt to net worth ratio
The total amount of money owed to shareholders in a year’s time as a percentage of the shareholder’s investment.
3. Total liabilities to net worth ratio
The relationship between the total debts and the owner’s equity in a company. The higher the ratio, the lower the protection for the business creditors.
When assessing the financial health of a company, one of the key considerations is the risk of insolvency, as it measures the ability of a business to sustain itself in the long term. The solvency of a company can help determine if it is capable of growth.
Also, solvency can help the company’s management meet their obligations and can demonstrate its financial health when raising additional equity. Any business looking to expand in the long term should aim to remain solvent.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: