Solvency

Solvency is defined as the quality or state of being solvent, relating to any individuals or businesses’ ability to pay off long-term debts including incurred interest.

In essence, solvency is the ability of an entity to continue operations into the foreseeable future.

Companies that become insolvent end up filing bankruptcy while solvency ratios can be performed by investors or analysts to evaluate a company’s ability to stay in business.

How is Solvency Determined?

Common solvency ratios used include the interest coverage ratio and debt-to-assets ratio.

Entities seeking to learn a company’s ability to pay interest on its debts use the interest coverage ratio.

Additionally, the debt-to-assets ratio provides insight as to whether a company has incurred too much debt in relation to the value of its assets.

Regarding solvency, there tends to be confusion regarding the differences between solvency and liquidity.

Solvency relates to an individual’s or company’s ability to meet long-term obligations.

In parallel, liquidity is best defined as a company’s capability to paying off short-term obligations, which must be immediately accessible or effortless exchanged into serviceable capital.

For prospective business creditors, investors can gain insight into a company’s liabilities through the total liabilities to net worth ratio, where the higher the ratio indicates less protection ensured to investors.

Depending upon the industry, solvency ratios can vary although universally solvency ratios that reflect lower solvency than the industry benchmark serves as precursors that an individual or company may experience financial difficulties in the foreseeable future.