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Solvency Meaning
Solvency is a firm’s ability to continue its operation for the foreseeable future. Solvent firms are capable of meeting long-term financial commitments, without compromising shareholders' equity. If a company fails to cover its liabilities, it becomes insolvent.
Investors and shareholders analyze a company's solvency based on shareholders' equity. Shareholders' equity is the difference between total corporate assets and total liabilities. Liquidity determines a firm's ability to meet short-term liabilities; solvency, on the other hand, measures the ability to run its operations long-term.
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- A positive solvency position indicates a firm’s ability to repay long-term financial obligations or liabilities. It signifies a firm's net worth. The metric determines whether a firm can operate long-term.
- Investors, shareholders, and financial institutions use this metric to examine a company's financial health.
- Solvency is measured using equity ratio, debt to equity ratio, debt to asset ratio, financial leverage ratio, and interest coverage ratio.
Understanding Solvency
Solvency in accounting and finance is defined as the positive net worth of a company. In other words, it is a measure of business assets left after settling liabilities—assets or funds available to shareholders. Therefore, a company that maintains a positive solvency position can remain operational in the long term. Moreover, for investments and loan extensions, banks prefer solvent businesses.
Think of it this way, if a company is liquidated immediately, will it have anything left for its shareholders? This crucial factor determines the book value of a firm. Also, If a small business owned by individuals becomes insolvent, it may result in personal liabilities for its owners. Therefore, it becomes essential for companies to assess their solvency position at regular intervals.
Liquidity is a firm's ability to meet current liabilities—but liquidity is a short-term concept. Solvency, on the other hand, can be defined as the ability of the company to run its operations in the long run—a long-term concept.
Video on Solvency
Solvency Measure
Now, let us have a look at some of the prominent solvency measures in accounting and finance and their significance:
1. Equity/Proprietary Ratio: It indicates whether a company is overvalued or undervalued. It is assessed as the fraction of a business entity's total shareholder equity and total assets.
A value of 1 denotes fair valuation and a lower ratio indicates undervaluation. A higher ratio, therefore, would signify overvaluation.
2. Assets to Equity Ratio: It is a fraction of a firm's total assets and total equity.
3. Debt to Equity Ratio: This measure evaluates whether a firm’s equity can cover its overall debt. It is computed by dividing the firm's total liabilities by total shareholders’ equity.
4. Debt to Assets Ratio: It is the firm's ability to repay business liabilities from its overall short-term and long-term assets. For calculation, total debt is divided by total assets.
5. Interest Coverage Ratio: It determines if a business possesses enough earnings before interests and taxes to pay off interests on debts. It is determined by dividing Earnings before Interests & Taxes (EBIT) by interest expenses.
Solvency Example
The following information is extracted from the financial statements of Intel Corporation (INTC) for the year ending on December 31, 2021:
| Particulars | Amount ($) |
|---|---|
| Total Assets | 168,406,000 |
| Total Liabilities | 73,015,000 |
| Total Shareholder Equity | 95,391,000 |
| Total Equity | 95,391,000 |
| Total Debt | 38,101,000 |
| Earnings Before Interest and Taxes | 22,300,000 |
| Cost of Interest | 597,000 |
Based on the given data, determine the solvency of Intel Corporation.
Solution:
Equity/Proprietary Ratio = Total Shareholder Equity / Total Assets
Equity/Proprietary Ratio = 95,391,000 / 168,406,000 = 0.566
Here, the proprietary ratio is lower than one—Intel's stocks are undervalued.
Assets to Equity Ratio = Total Assets / Total Equity
Assets to Equity Ratio = 168,406,000 / 95,391,000 = 1.765
Intel has good assets to equity ratio—the company can easily pay off its shareholders out of its assets.
Debt to Equity Ratio = Total Liabilities / Total Shareholders' Equity
Debt to Equity Ratio = 73,015,000 / 95,391,000 = 0.765
Here, the debt to equity ratio is below 1; so, instead of external liabilities, the company relies more on stockholders’ equity.
Debt to Assets Ratio = Total Debt / Total Assets
Debt to Assets Ratio = 38,101,000 / 168,406,000 = 0.226
Since the debt to assets ratio is low it signifies that the company has enough assets to settle its liabilities in case of liquidation.
Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Cost of Interest
Interest Coverage Ratio = 22,300,000 / 597,000 = 37.35
Intel’s interest coverage ratio is high—it can pay off interest expenses with a lower risk of default.
Solvency Risk
Companies often risk becoming insolvent—they may not have enough assets to meet their liabilities. A business with significant debt can go bankrupt. Therefore, investors and lenders check for solvency and profitability. These parameters determine a company's long-term efficiency and performance.
An insolvent enterprise holds a negative net worth; this can be determined from a firm's financial statements. Such firms have very low credit ratings—unpopular among investors and financiers.
Frequently Asked Questions (FAQs)
It is a firm's ability to fulfill financial obligations in the long run without jeopardizing shareholders' equity. It mirrors the financial health of a business—a measure of operational effectiveness and longevity.
It can be determined using solvency ratios:
1. Equity/Proprietary Ratio = Total Shareholder Equity / Total Assets;
2. Assets to Equity Ratio = Total Assets / Total Equity;
3. Debt to Equity Ratio = Total Liabilities / Total Shareholders' Equity;
4. Debt to Assets Ratio = Total Debt / Total Assets;
5. Interest Coverage Ratio = Earnings Before Interest and Taxes / Cost of Interest.
It is essential for a company's survival in the long run. Therefore, firms regularly analyze their ability to meet long-term liabilities. They also ascertain their liquidity—easy access to funds from investors and financiers.
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