What is solvency?
Solvency is a company’s ability to meet its long-term debts and financial obligations and continue operating into the future. A simple solvency check uses the balance sheet: assets minus liabilities equals shareholders’ equity. If that difference is positive, the company is solvent on a book-value basis.
Solvency in business operations
- Shareholders’ equity (assets − liabilities) provides a quick view of long-term financial health.
- Negative shareholders’ equity generally indicates insolvency and can signal no remaining book value if the business were liquidated.
- Negative equity is more common in early-stage companies; mature firms typically move toward positive equity.
- Solvency risk can increase from events such as expiring patents, adverse regulatory changes, large litigation judgments, or other shocks to future cash flows.
- Solvency differs from liquidity: a firm can be insolvent yet maintain short-term cash flow and operate for a period if it has sufficient liquidity.
Key solvency ratios and what they show
Use ratios to analyze different aspects of solvency and a firm’s ability to service long-term obligations:
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Solvency ratio: (Net income + Depreciation & Amortization) / Total liabilities
— Measures the ability to cover liabilities with earnings and non-cash charges. -
Interest coverage ratio: Operating income / Interest expense
— Shows how easily a company can pay interest on outstanding debt; higher is better. -
Debt-to-assets ratio: Total debt / Total assets
— Indicates how much of the asset base is financed by debt.
Other useful measures:
– Debt-to-equity
– Debt-to-capital
– Debt-to-tangible-net-worth
– Total liabilities to equity
– Total assets to equity
– Debt-to-EBITDA
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Note: “Healthy” ratio levels vary by industry—compare companies to appropriate industry benchmarks.
Solvency vs. liquidity
- Solvency = ability to meet long-term obligations.
- Liquidity = ability to meet short-term obligations (typically within one year).
Common liquidity measures:
– Working capital = Current assets − Current liabilities
– Current ratio = Current assets / Current liabilities
– Quick ratio = (Cash + Marketable securities + Receivables) / Current liabilities
– Working capital turnover = Sales / Average working capital
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A business can be insolvent yet survive temporarily if it has adequate liquidity. Conversely, a business without liquidity can fail quickly even if solvent on paper.
FAQs
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How is solvency determined?
The basic test is whether assets exceed liabilities (positive shareholders’ equity). Ratios like the solvency ratio and interest coverage provide deeper insight. -
Are solvency ratios the same for every company?
No. Acceptable levels depend on industry, business model and capital structure. -
Can a company survive if it is insolvent?
It can for a time if it has sufficient liquidity and cash flow, but persistent insolvency raises the risk of restructuring, creditor action, or closure.
Bottom line
Solvency is a key indicator of long-term financial health. Start with shareholders’ equity to get a quick read, then use solvency and coverage ratios for a deeper assessment. Always consider liquidity alongside solvency and benchmark ratios against industry standards for a complete view of financial strength.