Solvency is a firm’s ability to continue its operation for the foreseeable future. Solvent firms are capable of meeting long-term financial commitments, without compromising shareholders’ equity. If a company fails to cover its liabilities, it becomes insolvent.
Investors and shareholders analyze a company’s solvency based on shareholders’ equity. Shareholders’ equity is the difference between total corporate assets and total liabilities. LiquidityLiquidityLiquidity is the ease of converting assets or securities into cash. determines a firm’s ability to meet short-term liabilities; solvency, on the other hand, measures the ability to run its operations long-term.
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- A positive solvency position indicates a firm’s ability to repay long-term financial obligations or liabilities. It signifies a firm’s net worth. The metric determines whether a firm can operate long-term.
- Investors, shareholders, and financial institutions use this metric to examine a company’s financial health.
- Solvency is measured using equity ratio, debt to equity ratio, debt to asset ratio, financial leverage ratio, and interest coverage ratio.
Solvency in accounting and finance is defined as the positive 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. of a company. In other words, it is a measure of business assets left after settling liabilitiesLiabilitiesLiability is a financial obligation as a result of any past event which is a legal binding. Settling of a liability requires an outflow of an economic resource mostly money, and these are shown in the balance of the company.—assets or funds available to shareholders. Therefore, a company that maintains a positive solvency position can remain operational in the long term. Moreover, for investments and loan extensions, banks prefer solvent businesses.
Think of it this way, if a company is liquidated immediately, will it have anything left for its shareholders? This crucial factor determines the book valueBook ValueThe book value formula determines the net asset value receivable by the common shareholders if the company dissolves. It is calculated by deducting the preferred stocks and total liabilities from the total assets of the company. of a firm. Also, If a small business owned by individuals becomes insolventInsolventInsolvency is when the company fails to fulfill its financial obligations like debt repayment or inability to pay off the current liabilities. Such financial distress usually occurs when the entity runs into a loss or cannot generate sufficient cash flow., it may result in personal liabilities for its owners. Therefore, it becomes essential for companies to assess their solvency position at regular intervals.
Liquidity is a firm’s ability to meet current liabilities—but liquidity is a short-term concept. Solvency, on the other hand, can be defined as the ability of the company to run its operations in the long run—a long-term concept.
Video on Solvency
Now, let us have a look at some of the prominent solvency measures in accounting and finance and their significance:
1. Equity/Proprietary Ratio: It indicates whether a company is overvalued or undervalued. It is assessed as the fraction of a business entity’s total shareholder equityShareholder EquityShareholder’s equity is the residual interest of the shareholders in the company and is calculated as the difference between Assets and Liabilities. The Shareholders' Equity Statement on the balance sheet details the change in the value of shareholder's equity from the beginning to the end of an accounting period. and total assetsTotal AssetsTotal Assets is the sum of a company's current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equity.
A value of 1 denotes fair valuation and a lower ratio indicates undervaluation. A higher ratio, therefore, would signify overvaluation.
2. Assets to Equity Ratio: It is a fraction of a firm’s total assets and total equity.
3. Debt to Equity Ratio: This measure evaluates whether a firm’s equity can cover its overall debt. It is computed by dividing the firm’s total liabilities by total shareholders’ equity.
4. Debt to Assets Ratio: It is the firm’s ability to repay business liabilities from its overall short-term and long-term assets. For calculation, total debt is divided by total assets.
5. Interest Coverage Ratio: It determines if a business possesses enough earnings before interests and taxes to pay off interests on debts. It is determined by dividing Earnings before Interests & Taxes (EBIT) by interest expensesInterest ExpensesInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense..
The following information is extracted from the financial statements Financial Statements Financial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.of Intel Corporation (INTC) for the year ending on December 31, 2021:
|Total Shareholder Equity||95,391,000|
|Earnings Before Interest and Taxes||22,300,000|
|Cost of Interest||597,000|
Based on the given data, determine the solvency of Intel Corporation.
Equity/Proprietary Ratio = Total Shareholder Equity / Total Assets
Equity/Proprietary Ratio = 95,391,000 / 168,406,000 = 0.566
Here, the proprietary ratio is lower than one—Intel’s stocks are undervalued.
Assets to Equity Ratio = Total Assets / Total Equity
Assets to Equity Ratio = 168,406,000 / 95,391,000 = 1.765
Intel has good assets to equity ratio—the company can easily pay off its shareholders out of its assets.
Debt to Equity Ratio = Total Liabilities / Total Shareholders’ Equity
Debt to Equity Ratio = 73,015,000 / 95,391,000 = 0.765
Here, the 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. is below 1; so, instead of external liabilities, the company relies more on stockholders’ equity.
Debt to Assets Ratio = Total Debt / Total Assets
Debt to Assets Ratio = 38,101,000 / 168,406,000 = 0.226
Since the debt to assets ratioDebt To Assets RatioDebt to asset ratio is the ratio of the total debt of a company to the total assets of the company; this ratio represents the ability of a company to have the debt and also raise additional debt if necessary for the operations of the company. A company which has a total debt of $20 million out of $100 million total asset, has a ratio of 0.2 is low it signifies that the company has enough assets to settle its liabilities in case of liquidationLiquidationLiquidation is the process of winding up a business or a segment of the business by selling off its assets. The amount realized by this is used to pay off the creditors and all other liabilities of the business in a specific order..
Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Cost of Interest
Interest Coverage Ratio = 22,300,000 / 597,000 = 37.35
Intel’s 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. is high—it can pay off interest expenses with a lower risk of defaultRisk Of DefaultDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors..
Companies often risk becoming insolvent—they may not have enough assets to meet their liabilities. A business with significant debt can go bankrupt. Therefore, investors and lenders check for solvency and profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.. These parameters determine a company’s long-term efficiency and performance.
An insolvent enterprise holds a negative net worth; this can be determined from a firm’s financial statements. Such firms have very low credit ratings—unpopular among investors and financiers.
Frequently Asked Questions (FAQs)
It is a firm’s ability to fulfill financial obligations in the long run without jeopardizing shareholders’ equity. It mirrors the financial health of a business—a measure of operational effectiveness and longevity.
It can be determined using solvency ratios:
1. Equity/Proprietary Ratio = Total Shareholder Equity / Total Assets;
2. Assets to Equity Ratio = Total Assets / Total Equity;
3. Debt to Equity Ratio = Total Liabilities / Total Shareholders’ Equity;
4. Debt to Assets Ratio = Total Debt / Total Assets;
5. Interest Coverage Ratio = Earnings Before Interest and Taxes / Cost of Interest.
It is essential for a company’s survival in the long run. Therefore, firms regularly analyze their ability to meet long-term liabilities. They also ascertain their liquidity—easy access to funds from investors and financiers.
This article has been a guide on what is Solvency and its Meaning. Here we discuss solvency measures, ratios, calculations, examples, and risks. You may also have a look at the articles below to learn more about Corporate Finance –