Learn What Solvency Is in a Business
One of the primary objectives of a business is solvency. Along with liquidity and viability, solvency enables a business to keep going, to stay in business.
What Solvency Is
Solvency is the ability of a business to have enough assets to cover its liabilities. The business assets are the things the business owns, and the liabilities are what the business owes on those things. Why is this important? Every business has problems with cash flow occasionally, especially when starting into business. If the business has too many bills to pay and not enough assets (including cash, of course) to pay those bills, the business will not survive.
Solvency on the Business Balance Sheet
Solvency relates directly to the balance sheet of a business. The balance sheet shows the relationship of the business assets on the one side to its liabilities and equity (ownership) on the other side.
The traditional accounting equation is that Assets equal Liabilities plus Owner Equity. If a business has, say, $100,000 in assets and $100,000 in liabilities, the owner has no equity. The bank, so to speak, owns the business. But if the business has $100,000 in assets and only $50,000 in liabilities, the owner owns more of the business assets and can turn them into cash if needed.
Solvency Measures or Ratios
Solvency is often measured as a ratio of assets to liabilities. Remember, solvency compares assets to liabilities - are there enough assets to pay the bills? In these ratios, the best way to measure solvency is to include all liabilities: accounts payable, taxes payable, loans payable, leases payable - everything that the business owes. There are two ratios that measure solvency:
The current ratio is the total current assets divided by the total current liabilities. The current assets are cash, accounts receivable, inventory, and prepaid expenses. Other long-term assets like equipment aren't considered in this ratio because it takes too long to sell them to get money to pay the bills, and they won't sell for full value.
In order to be solvent and cover liabilities, a business should have a current ratio of 2 to 1, meaning that it has twice as many current assets as current liabilities. This ratio recognizes the fact that selling assets to obtain cash may result in losses, so more assets are needed.
The quick ratio uses only cash and accounts receivable, as these assets are the only ones that can be used to pay of debts quickly, in the case of an emergency cash need. The quick ratio is a 1 to 1 ratio, meaning cash and accounts receivable must equal the amount of debt. This, as you can imagine, is a more difficult ratio to achieve.
Solvency As Seen from a Lender's View
These ratios are important for the business owner, but also for a lender. If a bank is considering a loan to a business, it will look carefully at these ratios to determine if the business already has too much debt and not enough assets to pay off that debt.
Solvency, Liquidity, and Viability
Solvency is often confused with liquidity, but it is not the same thing. Liquidity is a short-term measure of a business, while solvency is a long-term measure. Liquidity relates more to short-term cash flow, while solvency relates more to long-term financial stability.
Solvency is also confused with viability. Viability relates more to the ability of a business to be profitable over a long period of time.