One of the primary objectives of any business is to have enough assets to cover its liabilities. This is known as solvency. Along with liquidity and viability, solvency enables businesses to continue operating.
Assets are the things businesses own, and the liabilities are what businesses owe on those assets. This is important because every business has problems with cash flow occasionally, especially when starting out. If businesses have too many bills to pay and not enough assets to pay those bills, they will not survive.
Solvency on the Balance Sheet
Solvency relates directly to a business' balance sheet, which shows the relationship of assets on one side to liabilities and equity (ownership) on the other side.
The traditional accounting equation is that Assets equal Liabilities plus Owner Equity. The two sides must balance since every asset must have been purchased either with debt (a liability) or the owner's capital (equity).
Solvency Measures or Ratios
Solvency often is measured as a ratio of assets to liabilities. For example, 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, and anything else the business owes. There are two ratios that measure solvency:
The current ratio is the total current assets divided by 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 off 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.
These ratios are important for both business owners and for lenders. 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 often is 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. Simply put, liquidity is the value of the cash a business could raise by selling off all its assets.
Solvency also is confused with viability. Viability relates more to the ability of a business to be profitable over a long period of time. Businesses with a track record of consistently turning profits year after year have viability. This adds to the overall value of a business because of the expectation that it can continue to turn profits moving forward.