Many companies focus primarily on profit, which is important, but in the attempt to increase profit, they first go into debt—putting their solvency at risk. To understand solvency we first need to understand what assets and liabilities are. An asset is cash or an item of economic value that can be turned into cash such as property or accounts receivable. Liabilities are anything that a company owes such as loans or accounts payable. In order for a company to be solvent, the company must have more assets than liabilities. In basic terms, it’s the ability for a company to meet its long-term financial obligations
Solvency vs. Liquidity
It’s important to note that solvency and liquidity are not the same thing. While solvency shows that a company can meet long-term debts, liquidity shows a company’s ability to pay short-term liabilities. A solvent company owns more than it owes, meaning that it has a positive net worth and manages debt well. A highly liquid company, on the other hand, may have enough cash on hand to pay all of its bills at the moment but could struggle in the long run. Healthy companies are solvent—and have a good amount of liquidity.
Take Note: Liquidity and solvency are often confused. While they are similar concepts, they serve different purposes. Learn more about the differences between the two here.
How Can We Determine a Company’s Solvency
There are many ways to do this, but one key way we can determine the solvency of a company is by looking at the solvency ratio. A solvency ratio measures if a company has enough cash flow to pay off their debts and other financial obligations. This ratio is important not only to the company when deciding about its financial future, but also to lenders to get the financial backing it needs.
Generally a company with a ratio at or above 20 percent is considered healthy, but it varies by industry. The lower the solvency ratio is for a company, the higher the chance that it will not meet its debt obligations.
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How to Calculate the Solvency Ratio
The easiest way to calculate this ratio is shown here:
Solvency Ratio = (Net Income + Non-Cash Expenses) / (Total Liabilities)
Net income can be calculated by subtracting your total expenses from total revenue. Non-cash expenses include amortization and depreciation. All of these items can be found on your income statement.
Total liabilities are calculated by adding your current (less than a year) plus long-term (over a year) liabilities. These can be found on the balance sheet.
Balance Sheet vs. Income Statement
Most metrics come from either the balance sheet or the income statement. It’s rare to run a calculation that requires information from both, but that’s the case with the solvency ratio. The reason it’s rare is that each report shows different things. The income statement shows performance over a set period of time (like a month or a quarter), while the balance sheet shows running totals over the life of your business. Unlike the income statement, the balance sheet is a snapshot that captures the state of your business on a single day.
When calculating the solvency ratio, be sure that you are looking at reports generated in the same period. For example, if you are calculating your solvency ratio at the end of last quarter, you would look at an income statement for the whole quarter and the balance sheet for the last day of the quarter.
Example of the Solvency Ratio in Action
Now let’s calculate a solvency ratio together.
Imagine that Bakery A has:
- A net income is $44,000.
- $20,000 in equipment depreciation.
- Current and long-term liabilities equal to $280,000.
This brings the solvency ratio to approximately 23%.
[$44,000(Net Income) + $20,000(Depreciation)] / $280,000(Total Liabilities) = 22.9% (Solvency Ratio)
Here, Bakery A’s solvency is above 20% which is healthy and will be looked at favorably by lenders.
In another instance, Bakery B has:
- A net income of $60,000.
- Equipment depreciation of $10,000.
- $5,000 in amortization from an outstanding loan.
- $450,000 in total liabilities.
Their solvency ratio comes out to approximately 17%
[$60,000 (Net Income) + $10,000 (Depreciation)] / $450,000 (Total Liabilities) = 16.7% (Solvency Ratio)
Bakery B’s solvency ratio is less than 20% which could be looked at unfavorably by lenders. It also goes to show that even though they are making a larger income than Bakery A, they appear less financially sound because they have taken on more debt.
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Why Should Businesses Care About Solvency?
It is necessary to stay solvent because it shows a company’s ability to stay in business. If a company owes more than it has in assets and stops meeting its financial obligations then it would become insolvent and most likely go into insolvency proceedings— meaning legal actions are taken to cash out the company’s assets to pay down their debts.
By keeping track of your company’s solvency ratio not only can you help reduce the risk of your company going bankrupt, but the ratios can also give you the bigger picture idea of whether or not you want to take on more debt. Not only do your solvency ratios help your business make important financial decisions to keep the company profitable, but it also gives lenders an idea on whether or not you would be able to pay off your debts. When lenders go through a company’s financial statement they will usually use the solvency ratio as the basis for creditworthiness. Companies with lower solvency ratios are seen as a bigger risk to banks and lenders. Lenders want to make sure that your business has the resources to pay off its debts.
What Factors Can Risk Solvency?
Certain circumstances can risk the financial security and solvency of a company, such as:
- A lawsuit that can require a company to pay large amounts of money
- Any special circumstances or regulations that prevent a company from performing or bringing in revenue as expected
- The expiration of a patent because competitors can produce the product in question and loose royalties payments associated with the product
- Taking on too much debt
- Not keeping track of your asset to liability ratios
How Your Company Can Stay Solvent
To boost your solvency ratio, the first step is to drive more profit. Simple, right? Maybe not so much. Although, something you can do is routinely go through your financial statements and calculate your solvency ratio. It is important to keep track of this number, so that your company doesn’t take on any debt that could hurt it in the long run.
Constantly combing through your financial statements can be a daunting task, but you don’t have to do it yourself. Using an accounting automation software like ScaleFactor can give you the detailed reports and insights you need, so that you don’t have to worry about going insolvent.