Solvency defines a company’s ability to meet its long-term debts and financial obligations. It helps demonstrate the firm’s financial performance and is a key indicator of whether it can manage its operations for the foreseeable future. A firm will be declared solvent if its current assets are worth more than its liabilities.
A company’s assets are items that it owns, such as cash, machinery, property, and inventory. Meanwhile, liabilities are what the business owes. Examples of a firm’s liabilities include utility bills, rent, company taxes, and staff wages. It’s important that a business has not only enough assets to cover its outgoings, but also build a solid foundation in case something unexpected comes along, or to fund future expansion.
It’s important to note that solvency should not be confused with liquidity. While they are both indicators of a company’s financial standing, the two terms are extremely different. Solvency is focused on the long term, while liquidity is about the here and now. Liquidity refers to the firm’s ability to cover its short-term obligations, and how easily it can sell assets to raise cash.
Businesses can therefore technically be insolvent but have high liquidity. This occurs when it has enough cash or easily-disposable assets to cover its short-term outgoings, but the total amount of these assets is worth less than its long-term obligations. Conversely, it’s also possible for a firm to have extremely low liquidity but still be solvent. In this scenario, the company’s assets will more than cover how much it owes, but it is unable to quickly sell them or convert them into cash. Examples of this include unpaid invoices, property, and stock.
For a company to be successful, it must have a good balance between solvency and liquidity, so it’s not only financially robust for the future, but can also weather short-term interruptions should they arise. A firm’s financial position can change rapidly, making it essential to carry out regular reviews to ensure that everything is running smoothly.