What Is Solvency? Definition, How It Works With Solvency Ratios

What Is Solvency?

Solvency is the ability of a company to meet its long-term debts and financial obligations. Solvency can be an important measure of financial health, since it's one way of demonstrating a company’s ability to manage its operations into the foreseeable future. The quickest way to assess a company’s solvency is by checking its shareholders’ equity on the balance sheet, which is the sum of a company’s assets minus liabilities.

How Solvency Works

Solvency portrays the ability of a business (or individual) to pay off its financial obligations. For this reason, the quickest assessment of a company’s solvency is its assets minus liabilities, which equal its shareholders’ equity. There are also solvency ratios, which can spotlight certain areas of solvency for deeper analysis.

Many companies have negative shareholders’ equity, which is a sign of insolvency. Negative shareholders’ equity insinuates that a company has no book value, and this could even lead to personal losses for small business owners if not protected by limited liability terms if a company must close. In essence, if a company was required to immediately close down, it would need to liquidate all of its assets and pay off all of its liabilities, leaving only the shareholders’ equity as a remaining value.

Carrying negative shareholders’ equity on the balance sheet is usually only common for newly developing private companies, startups, or recently offered public companies. As a company matures, its solvency position typically improves.

However, certain events may create an increased risk to solvency, even for well-established companies. In the case of business, the pending expiration of a patent can 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 also experience solvency issues should a large judgment be ordered against them after a lawsuit.

When studying solvency, it is also important to be aware of certain measures used for managing liquidity. Solvency and liquidity are two different things, but it is often wise to analyze them together, particularly when a company is insolvent. A company can be insolvent and still produce regular cash flow as well as steady levels of working capital.

Special Considerations: Solvency Ratios

Assets minus liabilities is the quickest way to assess a company’s solvency. The solvency ratio calculates net income + depreciation and amortization / total liabilities. This ratio is commonly used first when building out a solvency analysis.

There are also other ratios that can help to more deeply analyze a company's solvency. The interest coverage ratio divides operating income by interest expense to show a company's ability to pay the interest on its debt. A higher interest coverage ratio indicates greater solvency. The debt-to-assets ratio divides a company's debt by the value of its assets to provide indications of capital structure and solvency health. 

Other ratios that may be analyzed when considering solvency include:

• Debt to equity
• Debt to capital
• Debt to tangible net worth
• Total liabilities to equity
• Total assets to equity
• Debt to EBITDA

Solvency ratio levels vary by industry, so it is important to understand what constitutes a good ratio for the company before drawing conclusions from the ratio calculations. Ratios that suggest lower solvency than the industry average could raise a flag or suggest 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 levels if it has a negative book value.

One of the easiest and quickest ways to check on liquidity is by subtracting short-term liabilities from short-term assets. This is also the calculation for working capital, which shows how much money a company has readily available to pay its upcoming bills.

Short-term assets and short-term liabilities are those that have a one-year time frame. For example, cash and equivalents is a common short-term asset. Short-term accounts payable is a common short-term liability.

A company can survive with insolvency for a reasonable time period, but a company cannot survive without liquidity. Some interesting ratios that can be helpful in more deeply assessing liquidity can include:

• Quick ratio
• Current ratio
• Working capital turnover