Solvency

A solvent person has credit worthiness. Solvency in business or finance refers to the degree to which the current assets exceed the current liabilities of an individual or an entity. It can also be described as the ability of a corporate to meet its long term fixed expenses and to accomplish long term expansion and growth. A solvent individual or an entity would be able to meet its financial obligations.

A solvency ratio is a ratio to measure a company’s ability to meet its long term obligations. It measures the size of a company’s after-tax excluding non-cash depreciation expenses, as compared to the firm's total debt obligations. It helps in assessing how the company will be able to continue to meet its future obligations.

The measure is usually calculated as follows:

Solvency Ratio = (After Tax Profits + Depreciation)/ (long term liabilities + Short term liabilities

The industry average of solvency ratio differs from industry to industry. The higher the ratio is the better equipped a company is to pay off its debts and survive in the long term. In general a ratio of 20% or higher is considered to be a good ratio where as a ratio of 20% or lower is considered to be a bad ratio.

Some of the solvency ratios are:

• Quick ratios:  It is also called acid/liquid ratio. The formula for calculating quick ratio is Cash + Accounts Receivable/Current Liabilities
• Current Ratio This ratio is a comparison of current assets to current liabilities, commonly used as a measure of short-run solvency. The formula for calculating current ratio is Current Assets/Current Liabilities 
• Current Liabilities to Net Worth Ratio – This ratio indicates the amount due creditors within a year as a percentage of the owners or stockholders investment. (Net Worth= Total assets minus the outside liabilities). This ratio is calculated using the following formula: Current Liabilities/Net Worth

• Fixed Assets to Net Worth Ratio – This ratio shows the percentage of assets centered in fixed assets compared to total equity. This ratio is calculated using the following formula: Fixed Assets ÷ Net Worth

Questions

• What is solvency?
• What is solvency ratio?
• What are some of the solvency ratios?