Solvency
Candlefocus EditorSolvency is a measure of a company's overall financial health and stability by evaluating a company's balance sheet to determine its ability to pay its debts over a long period of time —usually more than three years. To assess a company's solvency, financial analysts and investors look at its liquidity ratios, leverage ratios, profitability ratios and cash flow to net worth ratios.
It should be noted that a company can be solvent but not liquid. When assessing solvency, liquidity should also be taken into account. A company with insufficient liquidity cannot meet its near-term obligations, even if the company is rated solvent in terms of long-term obligations.
Liquidity and solvency are closely related, but they are still different concepts. Liquidity is the company's ability to meet its short-term obligations and pay its bills on time, with an emphasis on cash management and access to credit or funds. Solvency, meanwhile, is the company's ability to pay its long-term debts. Solvency is evaluated differently from liquidity and involves looking at the company's cash flow over time.
Solvency is an important factor for investors to consider when examining the financial health of a company. Companies with a high level of solvency are typically more resilient and stable than companies with low levels of solvency. Companies that are highly leveraged and do not generate sufficient income to continue paying off both their current and future liabilities may be viewed as financially insecure investments.
Measures used to assess solvency include the current and quick ratios, leverage ratio, debt to equity ratio, solvency ratio and return on equity. The current and quick ratios measure a company's ability to pay short-term liabilities and determine if a company has enough liquid assets to cover its current obligations. The leverage ratio measures a company's debt to equity ratio, which indicates how much of its total capitalization is provided by borrowed funds. The debt to equity ratio measures the proportion of assets financed by debt versus equity. The solvency ratio is a combination of the current ratio and the debt to equity ratio and is used to evaluate a company's liquidity and solvency. Lastly, return on equity measures the rate of return a company's management is generating on shareholders’ investments.
In conclusion, solvency is a measure of a company’s ability to sustain its operations in the long-term by paying its debts and other financial obligations. Investors and financial analysts use ratios and other financial measures to evaluate a company's financial health and solvency. Companies with high levels of solvency are typically more stable and are seen as better investments than companies with low levels of solvency.