What is Solvency?

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Definition:

Solvency is a company’s capacity to pay off its long-term debts and financial obligations.

🤔 Understanding solvency

Solvency measures a company’s ability to pay long-term debts and interest on those debts. Solvency and liquidity are both measures of a firm’s financial health. While solvency focuses on long-term debts, liquidity signals the ability to pay short-term debts. Tracking a company’s solvency is vital for owners, investors, and creditors because it indicates how financially sustainable its operations are in the long run. To evaluate a firm’s solvency, stakeholders often use financial ratios that compare the total value of its assets and liabilities.

Example

One of the financial ratios used to evaluate solvency is the debt ratio:

Debt ratio = Total liabilities / Total assets

Let’s consider Square’s balance sheet for the fiscal year that ended Dec. 31, 2019:

Total liabilities: $2.83B Total assets: $4.55B Debt ratio: 2.83 / 4.55 = 0.62

(Source: Square’s 2019 Annual Report)

Square has a debt ratio of 0.62, meaning that its total debts are around 62 percent of its total assets.

Takeaway

Solvency is like a gauge on your car…

Your car comes with many gauges that measure different things, like gas level, engine temperature, and oil level. These tools display information about your car for you to interpret and decide whether there’s a potential issue. If one gauge shows an alert, you might look at other indicators to confirm whether there is an issue. Likewise, solvency provides you with one way to measure a company’s financial health that you can weigh along with many others.

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What is solvency?

Solvency refers to a company’s ability to meet its financial obligations in the long run. Companies have varying degrees of solvency. The more solvent a company is, the better equipped it likely is to sustain operations for a long time into the future.

A company is solvent when the total value of its assets (the sum of everything of value it owns) is higher than the value of its liabilities (the sum of all its debts). Assets and liabilities appear on a company’s balance sheet.

When a company becomes insolvent, it may eventually enter bankruptcy — a legal process in which the company declares it can’t pay its debts and works to settle with creditors.

How does solvency work?

Solvency is a measure of a company’s ability to meet recurring charges, like interest and other applicable fees, and eventually pay off the entire balance of its long-term debt. In general, solvency often refers to a company’s capacity to maintain more assets than liabilities. You can use different financial ratios to assess solvency.

Solvency is not static. You can analyze it over a specific period of time and must take into consideration events that could affect a company’s financial situation in the future.

For example, a valuable “intangible asset” — like a trademark, copyright, or patent — may expire within a couple of years, potentially decreasing the total value of a company’s assets and royalty income.

How do you calculate solvency?

Solvency can be calculated using the debt-to-equity ratio, the equity ratio, and the debt ratio.

Debt-to-equity ratio

Debt to equity ratio = Total liabilities / Total equity

For example, let’s consider Facebook’s balance sheet for the fiscal year ending Dec. 31, 2019:

Total liabilities: $32.32B Total equity: $101.05B Debt to equity ratio: 32.32 / 101.05 = 0.32

(Source: Facebook’s 2019 Annual Report)

A debt to equity ratio of 0.32 means that Facebook has 32 cents of debt for every dollar of equity.

Equity ratio

Equity ratio = Total equity / Total assets

The same balance sheet for Facebook lists the following:

Total equity: $101.05B Total assets: $133.37B Equity ratio: 101.05 / 133.37 = 0.76

(Source: Facebook’s 2019 Annual Report)

An equity ratio of 0.76 means that out of every one dollar of assets, Facebook owns 76 cents outright.

Debt ratio

Debt ratio = Total liabilities / Total assets

On Facebook’s balance sheet, you can see the following:

Total liabilities: $32.32B Total assets: $133.37B Debt ratio: 32.32 / 133.37 = 0.24

(Source: Facebook’s 2019 Annual Report)

A debt ratio of 0.24 means that Facebook has 24 cents of debt for every dollar of assets.

What is a good solvency ratio?

A good solvency ratio isn’t set in stone. Instead, you may want to:

  • Observe potential trends in financial ratios over time, like a steady increase or decrease over the last four quarters.
  • Compare a company’s financial ratios against those of peers in the same industry.
  • Evaluate the company’s financial ratios against industry benchmarks.

You can find the information you need to calculate the debt, debt-to-equity, and equity ratios for publicly traded companies in their quarterly and annual filings with the Securities and Exchange Commission (SEC). For private companies, you can use industry data from sources like Annual Statement Studies from the Risk Management Association or Dun & Bradstreet.

How do banks become insolvent?

Typically, a bank can become insolvent in two scenarios:

One of the ways a bank generates income is by issuing loans to individuals, companies, and other financial institutions using customer deposits. As long as the bank is capable of collecting loan payments and absorbing defaults with existing cash reserves, the business is sustainable.

A bank is solvent as long as its assets (cash reserves and loans) exceed its liabilities (customer deposits). However, if customers default on their loans, the bank has to write them off. If these “bad loans” grow to a point where the bank’s assets are worth less than its liabilities, then the bank becomes insolvent.

Alternatively, a bank may become insolvent if it gets into a cash crunch. If customers withdraw their cash in droves due to a financial crisis, then the bank could run out of money.

The bank can come up with additional money by liquidating assets or borrowing money from other banks, but the situation may become unsustainable. When left unchecked, "bank runs" can lead to insolvent banks. For example, in May 1984, Continental Illinois National Bank and Trust Company experienced so many withdrawals and claims from creditors that the bank eventually became insolvent, despite government intervention.

How can you tell which banks and credit unions are safest?

You can tell which banks and credit unions are safest by looking at whether or not their deposits are insured by the Federal Deposit Insurance Corporation (FDIC) or the National Credit Union Administration (NCUA). This is not an indicator of an institution’s solvency, but it helps protect certain deposits:

  • The FDIC insures up to $250,000 per depositor, per insured bank, for each type of eligible account, like checking accounts, savings accounts, money market accounts, and certificates of deposit. The FDIC also covers any bank-issued items like cashier checks and money orders. No one has ever lost any money in an FDIC-insured account since the agency was founded in 1933.
  • The NCUA insures up to $250,000 per share owner, per insured credit union, for each type of account. The NCUA insurance covers all types of deposit accounts, like checking accounts, savings accounts, money market accounts, and certificates of deposit.

You can check whether an institution is covered on the FDIC and NCUA websites.

Can a company be solvent but not profitable?

Solvency doesn’t guarantee profitability. Solvency measures whether total assets exceed total liabilities. Profit, meanwhile, measures total revenue minus total expenses. A company may be able to meet all of its debt in the long term and still not be able to turn a profit.

A company may have a profitable period but still be insolvent, and vice versa. However, the inability to turn a profit over several periods often forces a company to deplete assets and may lead to insolvency.

Alternatively, a company with several profitable periods typically increases its assets and pays down its debts (unless shareholders receive profits as dividends), which improves its solvency.

What is the difference between solvency and liquidity?

Solvency and liquidity are both ways to measure a company’s financial health. The main difference is that solvency is a company’s ability to meet long-term debts, and liquidity is a company’s ability to meet short-term debts.

Solvency measures the capacity to pay debts due over more than 12 months (such as a mortgage or employee pension liability). Liquidity measures the ability to meet financial obligations payable within 12 months (like a line of credit or short-term vehicle lease).

While solvency and liquidity consider different time frames, the measures are related. A company generally needs to keep an adequate level of liquidity to sustain solvency.

Why is solvency important?

Maintaining solvency is critical for a company to support business operations in the long run.

Owners, investors, creditors, financial analysts, and other stakeholders want to know how solvent a company is in order to make informed decisions.

By analyzing items from the balance sheet through financial ratios, they can develop a clearer picture of a company’s operations and sustainability.

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