What Is Solvency?

Solvency refers to a company's capacity to fulfill long-term debts and financial commitments, reflecting its financial health and operational longevity. A quick solvency check involves examiningshareholders’ equity, derived from the difference between assets and liabilities on the balance sheet.

Understanding Solvency in Business Operations

Solvency exists if a business or person canpay their debts. For this reason, the quickest assessment of a company’s solvency is its assets minusliabilities, 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 nobook 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 thebalance 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.

Certain events can raise solvency risks, even for strong companies. In the case of business, the pending expiration of apatent 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.

Analyzing Solvency With Key Ratios

Subtracting liabilities from assets is the easiest way to see a company's solvency. Thesolvency 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 ratios differ by industry, so know what's considered a good level for a company before judging its ratios. Ratios that suggest lower solvency than the industry average could raise a flag or suggest financial problems on the horizon.

Comparing Solvency and Liquidity: Key Differences

Solvency is about meeting all financial obligations, whileliquidity is about handling short-term ones. 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 forworking capital, which shows how much money a company has readily available to pay its upcoming bills.

Short-term assets and liabilities are those due within a year. 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 interestingratios that can be helpful in more deeply assessing liquidity can include:

• Quick ratio
• Current ratio
• Working capital turnover

The Bottom Line

Solvency is crucial for assessing a company's financial health, reflecting its ability to meet long-term obligations. A quick check of a company's balance sheet, specifically the shareholders' equity, can provide an immediate view of solvency. Solvency ratios, such as the solvency ratio and interest coverage ratio, offer deeper insights into a company's ability to sustain operations. However, solvency should be evaluated alongside liquidity to get a comprehensive picture; a company may remain operational despite insolvency if it maintains sufficient liquidity. Investors should also account for industry-specific solvency standards when analyzing financial statements to ensure accurate assessments.