Loading the player...

What is 'Solvency'

Solvency is the ability of a company to meet its long-term financial obligations. Solvency is essential to staying in business as it asserts a company’s ability to continue operations into the foreseeable future. While a company also needs liquidity to thrive, liquidity should not be confused with solvency. A company that is insolvent must often enter bankruptcy.

BREAKING DOWN 'Solvency'

Solvency directly relates to the ability of an individual or business to pay their long-term debts including any associated interest. To be considered solvent, the value of an entity’s assets, whether in reference to a company or an individual, must be greater than the sum of its debt obligations. Various mathematical calculations can be performed to help determine the solvency of a business or individual.

Solvency Ratios

Investors can use ratios to analyze a company's solvency. The interest coverage ratio divides operating income by interest expense to show a company's ability to pay the interest on its debt, with a higher result indicating a greater solvency. The debt-to-assets ratio divides a company's debt by the value of its assets to show whether a company has taken on too much debt, with a lower result indicating a greater solvency. Equity ratios demonstrate the amount of funds that remain after the value of the assets, offset by the outstanding debt, is divided among eligible investors.

Solvency ratios vary by industry, so it is important to understand what constitutes a good ratio for the company before drawing conclusions from the ratio calculations. Ratios that suggest a lower solvency than the industry average may suggest financial problems are on the horizon.

Risks to Solvency

Certain events can create a risk to an entity’s solvency. In the case of business, the pending expiration of a patent may pose risks to solvency as it will allow competitors to produce the product in question, and it results in a loss of associated royalty payments. Further, changes in certain regulations that directly impact a company’s ability to continue business operations can pose an additional risk. Both businesses and individuals may experience solvency issues should a large judgement be ordered against them after a lawsuit.

Solvency Vs. Liquidity

While solvency represents a company’s ability to meet long-term obligations, liquidity represents a company's ability to meet its short-term obligations. In order for funds to be considered liquid, they must be either immediately accessible or easily converted into usable funds. Cash is considered the most liquid payment vehicle. A company that lacks liquidity can be forced to enter bankruptcy even if it is solvent if it cannot convert its assets into funds that can be used to meet financial obligations.

RELATED TERMS
  1. Solvency Ratio

    One of many ratios used to measure a company's ability to meet ...
  2. Liquidity Ratios

    A class of financial metrics that is used to determine a company's ...
  3. Solvency Capital Requirement

    The amount of funds that insurance and reinsurance undertakings ...
  4. Keepwell Agreement

    A contract between a parent company and its subsidiary to maintain ...
  5. Free Asset Ratio - FAR

    A metric used to determine whether an insurance company has sufficient ...
  6. Current Ratio

    The current ratio is a liquidity ratio measuring a company's ...
Related Articles
  1. Investing

    Solvency Ratio

    The Solvency Ratio is one of many ratios used to measure a company's ability to pay its debts. Generally, the higher the ratio the better.
  2. Investing

    Financial Analysis: Solvency Vs. Liquidity Ratios

    Solvency and liquidity are equally important for a company's financial health. A number of financial ratios are used to measure a company’s liquidity and solvency, and an investor should use ...
  3. Investing

    Analyze Investments Quickly With Ratios

    There are four categories of financial ratios: profitability, liquidity, solvency and valuation.
  4. Investing

    What Is the Best Measure of a Company's Financial Health?

    Discover the single best financial metric that investors can use for determining the financial health and long-term sustainability of a company.
  5. Investing

    Liquidity Vs. Solvency

    Learn about the differences between these two words and how each one is used in the stock market.
  6. Investing

    Analyze Investments Quickly With Ratios

    Make informed decisions about your investments with these easy equations.
  7. Investing

    Key Financial Ratios to Analyze Tech Companies

    Understand the technology industry and the companies that operate in it. Learn about the key financial ratios used to analyze tech companies.
  8. Small Business

    Total Debt to Total Assets

    Total Debt to total assets, also called the debt ratio, is an accounting measurement that shows how much of a company’s assets are funded by borrowing. In business, borrowing is also called leverage.
  9. Investing

    Do Your Investments Have Short-Term Health?

    If a company is strong enough to survive tough times, it is more likely to provide long-term value.
  10. Investing

    Analyzing Oracle's Debt Ratios in 2016 (ORCL, SAP)

    Learn how the debt ratio, debt-to-equity ratio and debt-to-capital ratio are used to evaluate Oracle Corp.'s liabilities, equity and assets.
RELATED FAQS
  1. Are solvency ratios more concerned with the short-term or the long-term?

    Learn what solvency is, how to use ratios to determine a company's solvency, and why solvency ratios are concerned with the ... Read Answer >>
  2. How do unfunded capital expenditures and distributions affect the fixed charge coverage ...

    Learn about the most common solvency ratio and what it measures. Understand two other liquidity ratios that are commonly ... Read Answer >>
  3. What are the differences between solvency ratios and liquidity ratios?

    Learn about liquidity ratios and solvency ratios, some examples of these ratios and the main difference between them. Read Answer >>
  4. What can I tell about a company by looking at its solvency ratios?

    Learn about solvency ratios, how to calculate two solvency ratios and what solvency ratios indicate about a company when ... Read Answer >>
  5. How are liquidity ratios different than solvency ratios?

    Learn what liquidity and solvency are, what liquidity and solvency ratios calculate, and the main difference between the ... Read Answer >>
  6. What is the difference the operating cash flow ratio and solvency ratio?

    Learn about the operating cash flow ratio and the solvency ratio, what they measure, and the difference between the operating ... Read Answer >>
Hot Definitions
  1. Federal Direct Loan Program

    A program that provides low-interest loans to postsecondary students and their parents. The William D. Ford Federal Direct ...
  2. Cash Flow

    The net amount of cash and cash-equivalents moving into and out of a business. Positive cash flow indicates that a company's ...
  3. PLUS Loan

    A low-cost student loan offered to parents of students currently enrolled in post-secondary education. With a PLUS Loan, ...
  4. Graduate Record Examination - GRE

    A standardized exam used to measure one's aptitude for abstract thinking in the areas of analytical writing, mathematics ...
  5. Graduate Management Admission Test - GMAT

    A standardized test intended to measure a test taker's aptitude in mathematics and the English language. The GMAT is most ...
  6. Magna Cum Laude

    An academic level of distinction used by educational institutions to signify an academic degree which was received "with ...
Trading Center