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Every business needs to have solvency, or it’s game over very quickly, but just what does that mean in practical terms? Explore everything you need to know, starting with our solvency definition.
Solvency refers to a company’s ability to cover its financial obligations. But it’s not simply about a company being able to pay off the debts it has now. Financial solvency also implies long-term financial stability. Let’s explore this concept in a little more depth.
Short-term vs. long-term solvency
The long-term ability to cover financial obligations is known as solvency. In contrast, the ability to cover your short-term debts is known as liquidity, i.e., the proportion of your business’s assets that can be quickly liquidated. So, the term ‘solvency’ always means long-term solvency, as it’s possible for a company to have high liquidity but low solvency. This would imply that the business will soon face financial difficulty.
A healthy company will have a good amount of both short-term liquidity and long-term financial solvency.
Ratios for financially solvent companies
Assets and liabilities define solvency for a business. That is, a company needs enough assets comparative to its liabilities. Generally, businesses should aim to have twice as many assets as liabilities for a ratio of 2:1. Other ratios can also be measured to find how well-positioned a company is to cover debt, including:
Debt to inventory
Debt to net worth
Debt to capital
Debt to equity
Total liabilities to net worth
How to find a company’s financial solvency
To work out if a company is financially solvent, look at the balance sheet or cash flow statement. The former should show a higher value in assets than liabilities. A cash flow statement should reflect timely payment of debt, as well as the company’s ability to pay those debts. In addition, it should also provide an indication of how many liabilities the company has.
It’s important to remember that a company may have very few debts to pay while also exhibiting poor money management in other areas. So, while this can result in a healthy solvency ratio, the actual outlook for the company may not be as optimistic as this implies. Double entry bookkeeping will make it easy to see if money management needs to be tightened up.
Viability vs. solvency
Viability and solvency are both necessary for financial health, but they are not the same thing. While being financially solvent is centered around a company’s ability to pay off its debts in the long-term, viability refers to a business’s ability to turn a profit over a long period. Viability isn’t just about financials, but how well poised for success the business is as a whole, taking into account things like marketing, customer base, and competitive advantage.
What happens if a company is not financially solvent?
A company that is not financially solvent will need to secure a plan for debt repayment or go into administration. If a company is not solvent due to issues other than debt, then it may need to consider tools like a restructure, staff redundancy, or downsizing.
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