What is ‘Solvency’
Solvency is the ability of a company to meet its long-term financial obligations. Solvency is essential to staying in business as it asserts a company’s ability to continue operations into the foreseeable future. While a company also needs liquidity to thrive, liquidity should not be confused with solvency. A company that is insolvent must often enter bankruptcy.
BREAKING DOWN ‘Solvency’
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.
Investors can use ratios to 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, with a higher result indicating a greater solvency. The debt-to-assets ratio divides a company’s debt by the value of its assets to show whether a company has taken on too much debt, with a lower result indicating a greater solvency. Equity ratios demonstrate the amount of funds that remain after the value of the assets, offset by the outstanding debt, is divided among eligible investors.
Solvency ratios 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 a lower solvency than the industry average may suggest financial problems are on the horizon.
Risks to Solvency
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 judgement be ordered against them after a lawsuit.
Solvency Vs. Liquidity
While solvency represents a company’s ability to meet long-term obligations, liquidity represents a company’s ability to meet its short-term obligations. In order for funds to be considered liquid, they must be either immediately accessible or easily converted into usable funds. Cash is considered the most liquid payment vehicle. A company that lacks liquidity can be forced to enter bankruptcy even if it is solvent if it cannot convert its assets into funds that can be used to meet financial obligations.