Solvency, like liquidity, examines a business’s ability to pay its debt, although solvency concentrates on the ability to meet long-term obligations, while liquidity focuses on the ability to pay short-term obligations. Measured by ratios, financial solvency is important for the long-term survival of any business.
Overview: What is solvency?
The goal of any business owner is to have more assets than liabilities. In business, as in life, you always want to own more than you owe. That’s what solvency represents.
A business that is solvent is able to pay their bills both in the short term and long term. Solvency is usually measured using various accounting ratios, which include:
- Debt-to-asset ratio
- Debt-to-equity ratio
- Equity ratio
The results of these ratios indicate to business owners, investors, and financial institutions whether the business is likely to survive long term by looking at metrics such as the amount of debt assumed to increase assets, as well as the amount of equity used to fund assets.
We’ll explain more about these ratios, how to calculate them, and what the results mean later in the article.
Solvency vs. liquidity: What's the difference?
Solvency lets you take a look at the long-term financial health of your business, examining whether your business is in a position to meet all of its long-term obligations well into the future.
Rather than a short-term solution, solvency looks at the ability of a business to remain solvent. Insolvency occurs when a business can no longer pay money owed on any debt.
On the other hand, liquidity examines the short-term health of your business, determining whether your business can pay its short-term liabilities on time.
Liquidity also examines how quickly you are able to convert your assets into cash in a relatively short period of time. Lack of liquidity can affect the credit rating of your business, while insolvency can lead to bankruptcy.
There are numerous liquidity ratios that can be calculated to pinpoint liquidity levels, such as a quick ratio and current ratio, which are designed to look at the ability of a company to cover current debt.
Is solvency important for small businesses?
While assuming debt is part of doing business, as a business owner, you’re also tasked with walking the line between giving your business a financial boost and assuming too much debt too quickly, which can lead to a drop in your credit rating or even bankruptcy.
It’s vital that businesses of any size remain solvent, which means that you’re able to meet your long-term debt obligations. But how solvent is your business?
Luckily, it’s easy to calculate the solvency of your business using a few simple ratios. The results of these ratios can provide business owners with information such as the ability of your company to meet its future debt obligations as well as the possibility for long-term growth.
All of the numbers needed to calculate solvency ratios can be found on your balance sheet. Let's look at an example of a balance sheet for a small business.
Johnson Electronics Balance Sheet 5-31-2020
|Total Current Assets||$211,000|
|Total Fixed Assets||$255,000|
|Total Current Liabilities||$42,000|
|Long Term Liabilities|
|Total Owners' Equity||$313,000|
|TOTAL LIABILITIES & OWNERS' EQUITY||$466,000|
How to calculate your small business’ solvency
There are several ratios that can be performed to determine the solvency of your business. These ratios include the following:
Debt-to-asset ratio: The debt-to-asset ratio is probably the first ratio you should calculate, The debt-to-asset ratio measures the current amount of company assets that are funded by liabilities. The formula for the debt-to-asset ratio is:
Total Liabilities ÷ Total Assets = Debt-to-Asset Ratio
Using the balance sheet above, let's calculate this ratio for Johnson Electronics:
$153,000 ÷ $466,000 = 33%
That means that Johnson Electronics has 33% of its assets financed by debt. A good debt-to-asset ratio is 40% or lower, which is a direct indicator of your company’s ability to meet its financial obligations, while a ratio higher than 50% is considered higher risk.
Debt-to-equity ratio: The debt-to-equity ratio measures the amount of debt versus the amount of equity that your business uses to finance daily operations. The formula for calculating the debt-to-equity ratio is:
Long Term Debt ÷ Shareholder’s Equity = Debt-to-Equity
Here’s how we’ll calculate Johnson Electronics' debt-to-equity ratio using numbers from the balance sheet:
$111,000 ÷ $313,000 = $0.35
This result means that Johnson Electronics uses $0.35 of debt financing for every $1 of equity financing. A good debt-to-equity ratio is less than 1, which makes your business a more attractive investment.
Businesses that currently have a debt-to-equity ratio greater than 1 are considered leveraged, which is when they become a solvency risk as well as an investment risk.
Equity ratio: An equity ratio is designed to measure company leverage by determining how well a company manages debts and funds assets. The formula for calculating the equity ratio is:
Total Equity ÷ Total Assets = Equity
Using the numbers from the balance sheet, we’ll calculate Johnson Electronics' equity ratio:
$313,000 ÷ $466,000 = 0.67
The higher the equity ratio value, the less leveraged a business is considered. Companies with an equity ratio lower than 0.5 are considered leveraged, which means that they finance more assets using debt than equity. Those with a higher equity ratio fund more assets using equity.
When calculating any financial ratios, it’s important to do so on a regular basis, which will enable you to spot potential trouble areas before they become a threat to your business.
If you're comparing solvency ratio results with other businesses, be sure that you choose businesses within your industry, as results vary widely between industries.
Solvency is important for all businesses
Calculating solvency ratios is important for any business, large or small, but ratio analysis is just as important, since understanding the results of the calculations allows you to be proactive in making better management decisions.
For instance, if your company is over-leveraged, it’s best not to take on more debt, while a low debt-to asset ratio indicates that your business is solvent enough to perhaps take on additional debt to fund new projects.
If you’re struggling to keep track of your financial transactions manually, consider making the switch to accounting software, which will provide you with the accurate financial statements necessary to calculate solvency ratios for your business.