Solvency is the ability of a company to meet its long-term debts and other financial obligations.
Solvency is important; It serves as a barometer to measure your business’ ability to continue operating and to grow in the future.
Solvency versus liquidity
While solvency assesses whether you’re able to meet long-term debts, liquidity is a measure of your company’s ability to cover its short-term debts.
A company can be solvent but have bad liquidity, or the other way around. Both solvency and liquidity are important for your business to be successful.
You can see if your business has good liquidity by dividing short-term assets by short-term liabilities: If your current assets are $100 000 and current liabilities are $80 000 the calculation is 100,000 / 80,000 = 1.25
A ratio above 1 indicates that you have enough current assets to cover your expenses.
How to work out if your business is solvent
To see if your business is solvent, you compare your total assets with your total liabilities, not just short-term assets and liabilities.
You’d start by looking at your company’s balance sheet because it shows assets and liabilities. Then you can divide your liability by your assets. If the ratio is above 1, then you have a solvent company.
You should also look at the cash flow statement, as it shows short-term liabilities and assets and that’s important to monitor as well.
There are other types of solvency ratios: You can for example divide your debt by your assets, to see how much of your solvency comes from debts. If it’s above 1, then it means that you’re very reliant on your loans, which is not great for the long-term health of your business.
If you want help with the financial management of your business, you should speak to an accountant.