Solvency: Meaning & Definition

KEY TAKEAWAYS

• Solvency relates to how well a company can meet the financial obligations and long-term debts that they have.
• Investors often use various financial metrics and ratios to explore the solvency of a company. 
• Solvency is one of the measures you can use to look into the financial health of a company. This is since it helps to demonstrate their ability to manage business operations for the foreseeable future. 

What Is Solvency? 

Solvency is the ability of a specific company to meet the financial obligations and long-term debts that they have.

It’s an important measure to look into when exploring overall financial health. This is because it can demonstrate the ability of the company to manage its operations. 

To gain insights into the solvency of a company, the quickest way is by looking at the balance sheet and checking its shareholder’s equity. This relates to the total sum of the assets minus liabilities of a company. 

How Does Solvency Work?

Solvency basically shows insights into the ability that a company has to pay off its financial obligations, such as long-term debts. One of the most effective, and quickest, ways to do this is to assess its shareholder’s equity. To do this, you can look at the balance sheet and subtract the liabilities from the assets. 

As well, other financial metrics and solvency ratios can be used to help highlight certain areas. Doing this allows for a deeper analysis of the total solvency of a company. When a company has negative shareholder’s equity it can be a sign of insolvency. 

When this happens, it means that a company might have no book value. Having no book value can lead to small business owners seeing personal losses if they’re not protected by certain limited liability terms. 

Essentially, if a company is forced to close down immediately, it would then liquidate its assets in order to help pay off its liabilities. So the only remaining value would end up being the shareholder’s equity. 

A company that has a negative shareholder’s equity on its balance sheet can be common for startups, recently offered public companies, or developing private companies. So as the company evolves, grows, and matures, its overall solvency will likely improve with it. 

With all of that said, there are certain events that can add risk to the solvency of a company. And this is the case regardless if it’s a new company or one that’s well-established. For example, a patent that is pending expiration can create some risks since competitors might try to produce their own version of the patent. 

If this happens, there can be a loss in royalty payments that would have been associated with the original patent. As well, certain changes in regulations that end up impacting the ability of a company to continue its business operations effectively can also create a risk of solvency. 

How to Calculate Solvency

To calculate solvency, you can use the solvency ratio. All you need to do is divide a company’s after-tax net income and add back depreciation by the sum of its liabilities, which includes both short-term and long-term liabilities.

There can be a few different ways to determine the solvency of a company. If you use the solvency ratio, you can calculate it using the following formula:

(Net Income + Depreciation) / All Liabilities (Short-Term + Long-Term Liabilities) = Solvency Ratio

How to Assess the Solvency of a Business 

In order to assess the solvency of a business, you need to first look at its cash flow statement and balance sheet. The balance sheet is going to give an overview of the assets and liabilities that it holds. When a company has a realizable value of assets that are greater than liabilities, it’s considered to be solvent. 

On the flip side, the company can be considered insolvent if the realizable value of its assets is below the total liabilities. 

The cash flow statement of the company is also going to indicate if it’s solvent or not. This is since it generally focuses on how well the business can meet the short-term obligations and demands that it has. In essence, it’s able to analyze the ability of the company to pay its debts when they’re due. 

As well, the cash flow statement is going to provide insights into the history that the company has of paying its debt. It will show if there are lots of outstanding debts or if payments are regularly made to reduce the debt liability it has. 

Implementing a solvency analysis can help dive deeper into the company and highlight potential risks that might indicate a potential for insolvency. It’s able to uncover the history of any financial losses, bad company management, the inability to raise proper funding, or any non-payment of taxes and fees.

Solvency vs Liquidity 

Simply put, solvency is a representation of the ability a company has to meet its financial obligations. Liquidity represents the ability that a company has to meet its short-term obligations. If a company has a negative book value, it can be incredibly important to its liquidity levels. 

One of the easiest ways to do this is by subtracting the short-term liabilities from the short-term assets. This is essentially the same calculation you would use to determine working capital, which shows the amount of money a company has available to pay upcoming bills. 

Short-term assets and short-term liabilities have a time frame of less than one year. For example, cash and cash equivalents is a common example of a short-term asset. Whereas short-term accounts payable is an example of short-term liability. 

The easiest way to think about this is that a company can’t survive without liquidity, but it can survive, for a time, with insolvency. 

Example of Solvency

Solvency helps measure the ability of a company to meet financial obligations. Companies can go through short-term solvency, which gets calculated by dividing current assets by current liabilities. 

Or, through longer-term solvency, which gets calculated by dividing net worth by total assets. Yet, a business is still able to stay profitable even if it’s insolvent. 

For example, a company has been seeing steady growth and has reached a point where it wants to expand operations. This will contribute to further growth and help increase sales and revenue. 

However, what if the company wants to borrow money to help with the expansion, but isn’t able to repay debt from existing assets? If this happens, the lender could assume cash flows will increase due to the expansion and repayment obligations wouldn’t be an issue. 

Summary 

When looking into the financial health of a company, one of the biggest things to consider is its risk of insolvency. This is because it measures how well a company can sustain its operations over time. As well, the solvency of a company is able to help you determine whether or not it has growth capabilities.