Solvency, like profitability and liquidity, is an important concept within the financial world. It indicates the extent to which a company is able to meet its long-term financial obligations. It refers to the ratio of a company’s equity to borrowed capital. Healthy solvency is crucial to a company’s survival because it indicates its financial stability and ability to grow and invest. Below we will go into more detail about exactly what solvency means, why it is so important and how to calculate it.

What is solvency?

Solvency is a measure of a company’s financial stability. It shows the extent to which a company is able to repay its debts using its equity. A company that has high solvency has more equity than debt and is therefore financially sound. This means the company is less at risk of bankruptcy and more likely to survive in the long run.

How do you calculate solvency?

To calculate a company’s solvency, you need to compare two key figures: equity and total debts. Equity includes all of a company’s assets minus all of its debts. Total liabilities include all amounts the company owes to creditors, such as loans and outstanding bills.

The formula for solvency is:

Shareholders’ equity/total liabilities x 100%.

If the result is higher than 100%, the company has more equity than debt and is financially sound. If the result is lower than 100%, the company has more debt than equity and is more financially vulnerable. For example, suppose a company has equity of €100,000 and total debts of €50,000. The solvency would then be: €100,000 / €50,000 x 100% = 200% This means that the company has twice as much equity as debts, which is a positive indicator of the company’s financial health.

Sample solvency calculation

Let’s illustrate this with an example. Suppose a company has equity of €100,000 and debt of €50,000. Thus, the company’s total equity is €150,000. The solvency of this company is then: Solvency = 100,000 / 150,000 = 0.67 or 67% A solvency of 67% is generally considered healthy because the company has enough equity to meet its financial obligations. In addition to solvency, there are other financial ratios that are important in determining a company’s financial health, such as the liquidity ratio and the profitability ratio. These ratios combined with solvency can give a complete picture of a company’s financial situation.

Why is solvency important?

Solvency is important because it reflects a company’s financial stability. A company with high solvency has more equity than debt and therefore has more financial resources to absorb setbacks and grow. This also means that the company is less at risk of bankruptcy. On the other hand, a company with low solvency may struggle to repay its debts and may run into financial trouble if it is unable to manage its debts. This can lead to bankruptcy and loss of investments and jobs.

Conclusion

Solvency is an important financial ratio that indicates a company’s ability to meet its financial obligations. It gives investors and lenders confidence in the company’s financial stability and is therefore an important characteristic of a company’s financial health. Solvency can be calculated by dividing equity by total assets. A solvency of more than 67% is generally considered healthy.