Solvency

Solvency is defined as the quality or state of being solvent. This can relate to any individual, businesses, or entity’s ability to pay off long-term debts including incurred interest.

As such, solvency reflects the ability of an entity to continue operations into the foreseeable future.

Companies run the risk of becoming insolvent, which are often forced to file bankruptcy while solvency ratios can be performed by investors or analysts to evaluate a company’s ability to stay in business.

Why Solvency Matters

Solvency is extremely important in maintaining shareholder expectations. A company becoming insolvent is the fear of any market investor owning that company’s shares.

Common solvency ratios used include the interest coverage ratio and debt-to-assets ratio.

Entities looking to learn a company’s ability to pay interest on its debts use the interest coverage ratio.

Furthermore, the debt-to-assets ratio provides insight as to whether a company has incurred too much debt in relation to the value of its assets.

With regards to solvency, there often is confusion regarding the differences between solvency and liquidity.

Solvency relates to an individual’s or company’s ability to meet long-term obligations.

In parallel, liquidity is best defined as a company’s capability to pay off short-term obligations, which must be immediately accessible or effortlessly exchanged into serviceable capital.

For prospective business creditors, investors can gain insight into a company’s liabilities through the total liabilities to net worth ratio, where the higher the ratio indicates less protection ensured to investors.

Depending upon the industry, solvency ratios can vary tremendously.

Universally solvency ratios that reflect lower solvency than the industry benchmark serve as precursors that an individual or company may experience financial difficulties in the foreseeable future.