Solvency is a state in which your company is able to meet financial obligations, and more than often, debts that span over long periods of time.
Why does the solvency of a company matter?
Being solvent shows a business’s strength. It shines a positive light on the perception of your future because it suggests you’re looking after your current business operations.
These are a few more reasons why it’s important:
- It’s a necessity for ongoing trading. Usually no new debts can be taken on if your business is financially insolvent (and if they are, directors could be found personally liable for these new debts and any other wrongful acts). If the period of insolvency is just temporary, then trade can continue.
- It helps with business acquisition & sales. Planning on selling or expanding your business by acquiring another company? Having a record of solvency will make that process a whole lot smoother and attract investors.
- It improves your investment profile. If you’re looking to make a convincing case to be granted a loan, financial investment, or entice a new stakeholder you’ll want to illustrate long term financial health. Solvency is one way to do exactly that.
- It improves your new business profile. A business that’s solvent can be trusted and relied on to provide ongoing operations and services. A solvent business is known to provide solid service? Well, that’s a recipe for a great reputation and word-of-mouth marketing.
What’s the solvency ratio and how do I calculate it?
The solvency ratio is used to work out your company’s ability to meet your debts (including long-term and short-term liabilities). This is a metric often used by prospective lenders and investors when evaluating whether or not they’ll grant a business loan.
So when it comes to the solvency ratio, it’s another pretty important metric that gives an at-a-glance indication of your company’s financial health.
The lower your solvency ratio, the more likely your business is perceived to default. A higher solvency ratio means a greater likelihood of staying solvent. A 20% ratio or higher is considered healthy, though it does tend to differ across industries. Your best bet is to compare your company’s solvency ratio with other businesses in the same industry.
Here’s a look at the formula for the solvency ratio:
SOLVENCY RATIO = After-tax net income + Non-cash expenses / Short-term liabilities + Long-term liabilities
When is a business considered insolvent?
The reality is that it’s not always possible to stay solvent. There are occasions when UK-based businesses (for a variety of reasons) are not able to pay debts. Though no company wants to reach that stage (because those that do, often end up bankrupt), it’s still important to get to grips with different forms of insolvency in the UK to understand when that applies:
Cash flow insolvency happens when the assets your company owns are worth more than the value of your debts but you don’t have a suitable plan or form of payment to settle those debts and pay creditors on time.
Your company has £300,000 in liabilities and a company car worth £10,000. The property where your business operates from is valued at £750,000. On your balance sheet, those assets are shown to be greater than your liabilities but you’re not able to use those assets to settle debts because they’re not liquid assets. So you can’t pay creditors the cash. That makes your cash flow insolvent.
Balance sheet insolvency is when your company’s assets are less than its liabilities.
Your company has liabilities that add up to £600,000. Even with the office you own worth £300,000 and your company car that’s got a value of £10,000, you’ll still be considered balance sheet insolvent.
How is solvency different to liquidity?
The main difference here is time-frame. Solvency refers to being able to meet long-term obligations whereas liquidity refers to the ability to honor financial obligations that are short-term through its current assets..
- A business that’s solvent is considered “healthy” and able to cover long-term financial obligations. You can pay the bills, stay in business, and grow your business.
- Solvency ratio is used by investors or prospective lenders to determine the likelihood of your company’s ability to meet these obligations over time.
- Cash-flow insolvency is when your company’s assets exceed your liabilities but there is no cash available to settle the liability where, balance sheet insolvency is when your liabilities exceed your assets.
- Solvency refers to being able to pay long-term financial obligations while liquidity refers to a company’s ability to meet short-term obligations.