Definition: Solvency refers to the long-term financial stability of a company and its ability to cover its long-term obligations. In other words, it’s the ability of a company to meet short and long-term debts as they become due.
What Does Solvency Mean?
Both investors and creditors are concerned with the solvency of a company. Investors want to make sure the company is in good financial standings and can continue to grow, generate profits, and produce dividends. Basically, investors are concerned with receiving a return on their investment and an insolvent company that has too much debt will not be able to generate these types of returns.
Creditors, on the other hand, are concerned with being repaid. If companies can’t generate enough revenues to cover their current obligations, they probably won’t be able to pay off new obligations.
Both investors and creditors use solvency ratios to measure a firm’s ability to meet their obligations. The most common solvency ratios are the debt to equity ratio, debt ratio, and equity ratio.
The debt to equity ratio compares total liabilities to total equity. This is a comparison of how much money investors have contributed to the company and how much creditors have funded. The more the company owes to creditors, the more insolvent the company is.
The debt ratio compares total liabilities to total assets. This shows the amount of assets that are funded by creditors. Conversely, it shows how much assets would need to be sold in order to pay off the liabilities.
The equity ratio compares total liabilities to total assets. This shows what percentage of assets investors contribute.
Solvency can be viewed in two different ways. Short-term solvency usually focuses on the amount of cash and current assets that can be used to cover obligations. Long-term solvency typically focuses on the firm’s ability to generate future revenues to meet obligations in the future.