In finance or business, Solvency is the ability of a company to meet its long-term financial obligations. It is the degree to which the current assets of an individual or entity exceed the current liabilities of that individual or entity.
Solvency can also be described as the ability of a corporation to meet its long-term fixed expenses and to accomplish long-term expansion and growth. This is best measured using the net liquid balance (NLB) formula. In this formula, solvency is calculated by adding cash and cash equivalents to short-term investments, then subtracting notes payable.
Solvency is essential to staying in business as it demonstrates a company’s ability to continue operations into the foreseeable future. While a company also needs liquidity to thrive and pay off its short-term obligations, such short-term liquidity should not be confused with solvency. A company that is insolvent will often enter bankruptcy.
Solvency directly relates to the ability of an individual or business to pay their long-term debts including any associated interest. To be considered solvent, the value of an entity’s assets, whether in reference to a company or an individual, must be greater than the sum of its debt obligations. Various mathematical calculations can be performed to help determine the solvency of a business or individual.
Certain events can create a risk to an entity’s solvency. In the case of business, the pending expiration of a patent may pose risks to solvency as it will allow competitors to produce the product in question and it results in a loss of associated royalty payments. Further, changes in certain regulations that directly impact a company’s ability to continue business operations can pose an additional risk. Both businesses and individuals may experience solvency issues should a large judgment be ordered against them after a lawsuit.
Solvency on the Balance Sheet – Solvency relates directly to a business’ balance sheet, which shows the relationship of assets on one side to liabilities and equity (ownership) on the other side.
The traditional accounting equation is that Assets equal Liabilities plus Owner Equity. The two sides must balance since every asset must have been purchased either with debt (a liability) or the owner’s capital (equity).
The cash flow statement also provides a good indication of solvency, as it focuses on the business’s 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 a 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.
Solvency, Liquidity, and Viability –
Solvency often is confused with liquidity, but it is not the same thing. Liquidity is a short-term measure of a business, while solvency is a long-term measure. Liquidity relates more to short-term cash flow, while solvency relates more to long-term financial stability. Simply put, liquidity is the value of the cash a business could raise by selling off all its assets.
Solvency also is confused with viability. Viability relates more to the ability of a business to be profitable over a long period of time. Businesses with a track record of consistently turning profits year after year have viability. This adds to the overall value of a business because of the expectation that it can continue to turn profits moving forward.
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.