Solvency is the ability of a company to meet its long-term debts and other financial obligations.
Solvency is important in finance and business, and representing the extent the current assets surpass the current debt. It serves as a barometer for their ability to meet long-term financial obligations, demonstrating their capacity for sustained operations and growth.
The primary goal of solvency involves comparing a company’s total assets to its total liabilities, with solvency confirmed if current assets exceed current liabilities. This evaluation is often quantified through the current ratio, where a ratio greater than 1:1 indicates solvency. A solvent company can meet its long-term goals, achieve expansion, and fulfill financial commitments over time.
Solvency vs. liquidity
While solvency addresses long-term obligations, liquidity concentrates on a company’s ability to settle short-term debts with available assets.
Liquidity is determined by subtracting short-term liabilities from short-term assets. Both solvency and liquidity are distinct indicators, and a company ideally should maintain a balance of both to stay competitive.
Assessing solvency
A solvency analysis involves examining a company’s balance sheet and cash flow statement.
The balance sheet provides an overview of assets and liabilities, with solvency affirmed if realisable asset value surpasses liabilities. The cash flow statement assesses the company’s ability to meet short-term obligations, analysing both the historical payment of debts and readiness to cover upcoming liabilities.
Solvency ratios
Numerous ratios contribute to a deeper understanding of solvency:
- Current debts to inventory ratio: Evaluates a company’s reliance on current inventory to meet debt obligations.
- Current debt to net worth ratio: Expresses the total owed to shareholders in a year as a percentage of shareholder investment.
- Total liabilities to net worth ratio: Examines the relationship between total debts and owner’s equity, indicating creditor protection.
Solvency determination
Solvency can be determined through basic formulas, such as subtracting liabilities from assets. If the resulting value is positive, the company is considered solvent. Additionally, the net liquid balance (NLB) formula is employed, calculating solvency by adding cash, short-term investments, and subtracting notes payable.
Special considerations
Solvency can be impacted by factors like expiration, regulatory changes or legal judgments. It this happens there is a need for ongoing assessment. Solvency ratios, including the interest coverage ratio and debt-to-assets ratio, offer nuanced insights into a company’s financial health and capital structure.