Reviewed by Oct 05, 2020| Updated on
Solvency refers to a company’s ability to be able to meet its liabilities and other financial obligations. The solvency or otherwise of a company shows its financial health and in turn its ability to carry on business. A company which is not able to generate sufficient cash from operations and pays its debt obligations risks become insolvent.
Various analytical tools and ratios are available to test the financial health of a company. The most common way is to check the debt to equity ratio of the company. The debt-equity ratio is the ratio of the debt liabilities to the shareholder’s capital. A debt-equity greater than 1 shows the high proportion of debt on the company’s balance sheet.
There are other measures to assess a company’s ability to pay its debt. Another way to test the ability is by reducing the liabilities from the assets of the company. The result of the reduction shows the amount of equity in the company. In case a company has negative equity, the company’s financials are under stress. Negative equity shows that the company has no book value left for its shareholders.
In general, a newly formed company, a start-up company, or a recently listed company has negative equity. As the company grows, its financial position also improves whereby it creates value for its shareholders. It is important to maintain the solvency position in order to be able to raise capital or debt from the market.
In certain cases, well-established companies tend towards insolvency due to regulatory issue, mismanagement of the company’s affairs, and other reasons. Many times, a company may spend a huge amount on research and development costs putting its finances to risk. A failure of the product may lead to the insolvency of the company.
While analysing the risk of insolvency, it is important to analyse the liquidity position of the company. An improving liquidity position may help the company in getting its finances in order. The other ratios analysing a company’s finances include interest coverage ratio indicating the debt servicing capability of a company. Also, solvency ratios or financial ratio vary between different types of industries.