Solvency - What is solvency?
Solvency refers to the financial health of a company where the company’s assets exceed its liabilities and the business is able to pay all its debts.
To check if your company is solvent, you will need to consult your balance sheet and profit & loss statement. Check out our blog on how to read reports and evaluate your year.
Solvency is used by potential lenders to identify if the company will be able to repay them, but also calculated by the company to determine its financial status at any given time. If the company has a poor solvency ratio, then the company may decide to close.
What is the difference between solvent and insolvent?
A company is solvent when its assets exceed its liabilities, and the company is able to pay off any debts owed.
A company is insolvent if its liabilities exceed its assets, and the company is not able to pay off its debts.
Calculating the solvency of a company determines the overall financial health of the business, and whether it will be able to operate long-term. It is also a factor to determine if a business should close its doors and go into liquidation.
How to calculate solvency
To determine if a company is solvent, you will have to calculate the solvency ratio. The solvency ratio is the main measure of if the company is able to meet its debt commitments.
The calculation for the solvency ratio is:
(Net income + Depreciation) ÷ All liabilities
Potential lenders will use this calculation instead of just the net income to determine the overall financial position of the business, and its capacity to stay afloat.
A good solvency ratio depends on the type of business you run, but generally, if the solvency ratio is higher than 20%, the business is considered financially strong.
Where can I find solvency information on my accounting reports?
Depreciation is the amount in which an asset decreases in value over time. It is a good indication of the long-term stability of a business. It can be calculated using invoicing software and found in the asset section on the company’s balance sheet
A liability is any debt owed by a business to a supplier, bank, lender, etc. Liabilities can be found on the balance sheet, across from the asset section.
What happens if my company is not solvent?
If your company is not solvent, but insolvent, then this means that your business is not financially healthy and you have more debt than income.
If this is the case, you will need to determine a business plan to increase your profits, while decreasing your debt.
If this is not possible, then you can look at the option of selling your company, or closing it down completely.
The best way to prevent insolvency is to stick to a realistic budget, and run reports on a regular basis to determine which practices are working, and which ones aren’t.