Solvency

Solvency Meaning

Solvency of the company means its ability to meet the long term financial commitments, continue its operation in the foreseeable future and achieve long term growth.

Solvency is the ability of the firm to continue its operations for a long period of time and helps us understand whether a firm is stout enough to pay off long-term debt. The basic difference between liquidity and solvencyDifference Between Liquidity And SolvencyLiquidity is a short term concept referring to an entity's ability to pay off it's current liabilities. Solvency, on the other hand, can be defined as the ability of the company to run its operations in the long run. As a result, solvency is viewed as a long-term concept.read more is all about the firm’s ability to pay off the short-term debt (in the case of liquidity) or long-term debt (in the case of solvency).

Here, instead of taking a company’s example, we will try to understand solvency from an individual’s perspective. Taking an individual’s perspective will ease off the process, and an investor who is investing in a company individually would be able to understand when to go for a big investment and when to retreat.

Solvency

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Source: Solvency (wallstreetmojo.com)

Example

Let’s say that Mr. Goddin wants to invest in a company. His friend told him that it’s a very good idea to invest in that particular company since the company is doing quite well. But Mr. Goddin isn’t sure whether he has enough money to get into something.

So he goes to one of his friends who invest in companies. The friend tells him to look at the solvency of his own individual account.

Here’s what Mr. Goddin comes up with –

Assets –

  • Cash – $50,000
  • House – $200,000
  • Car – $15,000
  • Other Assets – $10,000

Liabilities –

  • Educational loan for his first child – $30,000
  • Mortgage on the house – $100,000
  • Credit Card Debt – $20,000

Mr. Goddin now decides to find out how much total assets he owns and how much total liabilities he has to pay off.

Total Assets –

  • Cash – $50,000
  • House – $200,000
  • Car – $15,000
  • Other Assets – $10,000
  • Total assets – $275,000

Total Liabilities –

  • Educational loan for his first child – $30,000
  • Mortgage on the house – $100,000
  • Credit Card Debt – $20,000
  • Total liabilities – $150,000

Now Mr. Goddin wants to know his net worth. His investor friend mentions that after liquidating all his assets and liabilities, if Mr. Goddin sees that he is still left with a positive net worth, he should go ahead and invest in that particular company his another friend suggested.

If Mr. Goddin finds that his net worth is negative, then it’s better first to pay off all his additional debt.

So Mr. Goddin deducts his total liabilities from his total assets and comes up with the following –

Net Worth Formula = (Total Assets – Total Liabilities) = ($275,000 – $150,000) = $125,000.

From the above calculation, Mr. Goddin gets clear about whether he should invest in a new company right now or not. Since his net worth is positive and he would have a healthy amount in his pocket even after paying off all he owes, he decides to go ahead with the investment.

Solvency of a Company

Now, if you are running a business and you want to invest in a project or buy a chunk of shares of a new start-up, first you need to find out how much net worthNet WorthThe company's net worth can be calculated using two methods: the first is to subtract total liabilities from total assets, and the second is to add the company's share capital (both equity and preference) as well as reserves and surplus.read more your company has. If your company is liquidated immediately, can your company be able to survive for some time, at least?

For companies, the approach would be a bit different because, in the case of companies, you need to think through your fixed expenses, your variable expenses every month, your production cost/servicing cost, and so on and so forth.

So as a company owner, you need to make sure that you have at least 6 months to 1 year of working capitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It's a measure of a company's liquidity, efficiency, and financial health, and it's calculated using a simple formula: "current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)"read more ready before investing in any new project.

Plus, the company can use debt to equity ratioDebt To Equity RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. read more and interest coverage ratioInterest Coverage RatioThe interest coverage ratio indicates how many times a company's current earnings before interest and taxes can be used to pay interest on its outstanding debt. It can be used to determine a company's liquidity position by evaluating how easily it can pay interest on its outstanding debt.read more to find out whether the firm is able to pay off its long-term debt or not.

The debt to equity ratio would tell the company whether its equity is enough to pay off the debt. Or else, the firm can check its income statement and can find out the EBIT and the interest charges for debt payment. And they will get an idea about whether they have enough earnings before interest and taxes to pay off the interest payment for a debt.

However, whether to invest in a project or not is completely a different ball game altogether.

Video on Solvency

This article has been a guide on what is Solvency and its meaning. Here we discuss how to calculate the Solvency of an individual and company along with examples. You may also have a look at these articles below to learn more about Corporate Finance –