What is solvency?
Solvency is a company’s ability to meet its long-term debt and financial obligations. Solvency can be an important measure of financial health as it is a way to demonstrate a company’s ability to conduct its business for the foreseeable future. The quickest way to gauge a company’s solvency is to check its equity on the balance sheet, which is the sum of a company’s assets minus liabilities.
This is how solvency works
Solvency describes the ability of a company (or an individual) to meet its financial obligations. For this reason, the quickest assessment of a company’s solvency is the assets minus liabilities equal to its equity. There are also solvency ratios that can highlight certain areas of solvency for deeper analysis.
Many companies have negative equity, which indicates bankruptcy. Negative equity assumes that a company has no book value and this could even result in personal loss for small business owners if it is not protected by liability restrictions when a company has to close. Essentially, to close immediately, a company would have to liquidate all of its assets and pay off all of its liabilities, with only equity remaining as a residual.
Equity on a company’s balance sheet can be a quick way to review a company’s solvency and financial health.
Negative equity on the balance sheet is typically only common in emerging private companies, startups, or recently launched public companies. As a company matures, its solvency position usually improves.
However, certain events can also present an increased solvency risk for incumbent companies. In business terms, the imminent expiration of a patent can pose a solvency risk as it allows competitors to manufacture the product in question and it leads to a loss of related royalty payments. In addition, changes in certain regulations that directly affect a company’s ability to continue operating can create an additional risk. Both companies and individuals can also face solvency problems if a large judgment is ordered against them after legal proceedings.
When analyzing solvency, it is also important to know certain measures for liquidity management. Solvency and liquidity are two different things, but it is often wise to analyze them together, especially if a company is bankrupt. A company can be insolvent and still generate regular cash flow and constant working capital.
The central theses
- Solvency is a company’s ability to meet its long-term debt and other financial obligations.
- Solvency is a measure of a company’s financial health as it shows a company’s ability to run its business for the foreseeable future.
- Investors can use metrics to analyze a company’s solvency.
- In solvency analysis, it usually makes sense to also evaluate liquidity ratios conjunctively, especially since a company can be insolvent, but still generates a constant level of liquidity.
Special considerations: Solvency ratios
Assets minus liabilities is the fastest way to gauge a company’s solvency. The solvency ratio calculates net profit + depreciation / total liabilities. This ratio is typically used first when performing a solvency analysis.
There are also other metrics that can help analyze a company’s solvency in more detail. Interest coverage divides operating income by interest expense to show a company’s ability to pay interest on its debt. A higher interest coverage ratio indicates a higher solvency. The debt to asset ratio divides a company’s debt by the value of its assets to provide clues about capital structure and solvency health.
Other metrics that can be analyzed when looking at solvency are:
- Debt to Equity
- Debt to capital
- Debt at net tangible value
- Total liabilities to equity
- Total assets to equity
- Debt to EBITDA
Solvency ratios vary by industry, so it is important to understand what a good metric is for the company before drawing any conclusions from the metric calculations. Metrics that suggest that solvency is lower than the industry average could send a signal or indicate financial problems on the horizon.
Solvency vs. Liquidity
While solvency represents a company’s ability to meet all of its financial obligations, generally the sum of its liabilities, liquidity represents a company’s ability to meet its short-term obligations. This is why it can be especially important to check a company’s liquidity when it has a negative book value.
One of the easiest and fastest ways to check liquidity is to subtract current assets minus current liabilities. This is also the working capital calculation, which shows how much money a company has available to pay its upcoming bills.
Current assets and current liabilities are those that have a time frame of one year. For example, cash and equivalents are a common short-term asset. Short-term trade payables are a common short-term liability.
A company can survive with bankruptcy for a reasonable amount of time, but a company cannot survive without liquidity. Some interesting metrics that can be helpful in assessing liquidity more precisely include:
- Fast relationship
- Current relationship
- Turnover of working capital