What is Solvency?
Solvency is the ability of a company to meet its long-term financial obligationsLong Term DebtLong Term Debt (LTD) is any amount of outstanding debt a company holds that has a maturity of 12 months or longer. It is classified as a non-current liability on the company’s balance sheet. The time to maturity for LTD can range anywhere from 12 months to 30+ years and the types of debt can include bonds, mortgages. 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 assetsCurrent AssetsCurrent assets are all assets that a company expects to convert to cash within one year. They are commonly used to measure the liquidity of a exceed current liabilitiesCurrent LiabilitiesCurrent liabilities are financial obligations of a business entity that are due and payable within a year. A company shows these on the. This is typically measured using the current ratioCurrent Ratio FormulaThe Current Ratio formula is = Current Assets / Current Liabilities. The current ratio, also known as the working capital ratio, measures the capability of a business to meet its short-term obligations that are due within a year. The ratio considers the weight of total current assets versus total current liabilities. It indicates the financial health of a company. 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 over 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, whether the current liabilities can be paid with the current assets on hand. Liquidity also measures how fast a company is able to covert its current assets into 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 have low liquidity, or vice versa. However, in order to stay competitive in the business environment, it is important for a company to be both adequately liquid and solvent.
Assessing the Solvency of a Business
The solvency of a business is assessed by looking at its balance sheetBalance SheetThe balance sheet is one of the three fundamental financial statements. The financial statements are key to both financial modeling and accounting. and cash flow statement.
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 statementCash Flow StatementA cash flow Statement contains information on how much cash a company generated and used during a given period. 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, having cash readily available to cover the obligations.
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 debt 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 uncover a history of financial losses, the inability to raise proper funding, bad company management, or non-payment of fees and taxes.
Several different ratios can help assess the solvency of a business, including the following:
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, expressed 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 equityOwner’s EquityOwner’s Equity is defined as the proportion of the total value of a company’s assets that can be claimed by the owners (sole proprietorship or partnership) and by the shareholders (if it is a corporation). It is calculated by deducting all liabilities from the total value of an asset (Equity = Assets – Liabilities). 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 over 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)™Become a Certified Financial Modeling & Valuation Analyst (FMVA)®CFI’s Financial Modeling and Valuation Analyst (FMVA)® certification will help you gain the confidence you need in your finance career. Enroll today! certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful:
- Analysis of Financial StatementsAnalysis of Financial StatementsHow to perform Analysis of Financial Statements. This guide will teach you to perform financial statement analysis of the income statement,
- Debt to Assets RatioDebt to Assets RatioThe Debt to Assets Ratio is a leverage ratio that helps quantify the degree to which a company’s operations are funded by debt. In many cases,
- Liquidity EventLiquidity EventA liquidity event is a process by which an investor liquidates their investment position in a private company and exchanges it for cash. The main purpose of a liquidity event is the transfer of an illiquid asset (an investment in a private company) into the most liquid asset – cash.
- Net Tangible AssetsNet Tangible AssetsNet Tangible Assets (NTA) is the value of all physical (“tangible”) assets minus all liabilities in a business. In other words, NTA are the