Whatever stage your business is at, it’s important to understand the difference between solvency and insolvency. When a business is solvent, it means it can meet its long-term debt obligations. When a business is unable to cover those debts (even if it liquidated all of its assets), it is considered insolvent. Financial solvency is essential for the long-term survival of any business.
Read on to learn how solvency works, how it is measured, and what to do if your business is not currently solvent.
What Is Solvency?
Solvency is the ability of a company to meet its financial obligations. In other words, the business’s assets exceed its liabilities. Because solvency shows a company’s ability to manage its operations into the foreseeable future, it is considered a key measure of the financial health of any business, no matter what size or industry it is in. Solvency is also necessary to qualify for many types of small business loans.
While solvency is often confused with liquidity, they are two different metrics. Solvency shows your ability to repay long-term debt, while liquidity shows your ability to repay short and mid-term debt. Liquidity only looks at assets that can be quickly converted into cash. It’s actually possible for a business to be insolvent (it has more liabilities than assets) but still have enough cash to cover its near-term financial obligations.
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How Solvency Works
Because solvency shows a company’s ability to pay off its financial obligations, the quickest way to measure it is to look at its owners’ (or shareholders’) equity, which is the company’s assets minus its liabilities.Let’s use fictional company XYZ as an example.
XYZ’s assets: $4,000,000
XYZ’s liabilities: $2,000,000
XYZ’s owners’ equity: $2,000,000
Company XYZ is solvent due to its positive owners’ equity. There are also other ratios that can help to more deeply analyze a company’s solvency. These include:
• Interest coverage ratio To get this ratio, you divide operating income by interest expense to show your company’s ability to pay the interest on its debt. A higher interest coverage ratio indicates greater solvency.
• Debt-to-assets ratio This divides a company’s debt by the value of its assets to provide indications of capital structure and solvency health.
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<2>What Is Insolvency?
Small business owners commonly take out business loans to expedite growth. If a company takes on too much debt too quickly, however, it can lead to insolvency – a state in which a company can no longer pay off its debts because its assets are insufficient to meet its liabilities.
Many companies have negative owners’ equity, which is a sign of insolvency. This means the business has no book value and, should the company close (liquidating all of its assets to pay off all of its liabilities), it could lead to a personal loss for the owners if they are not protected by limited liability terms.
It’s not uncommon for new small businesses and start-ups to have negative owners’ equity on the balance sheet. As a company matures, generally its solvency improves.
How Insolvency Works
Businesses can also move the other way, going from solvent to insolvent. This can happen for a variety of reasons, including poor cash management, a reduction in cash inflow, an increase in expenses, lawsuits, and/or not adapting to changes in the marketplace.
When a company is insolvent, it means its liabilities exceed its assets. Here’s an example using fictional company ABC.
ABC’S total assets: $3,000,000
ABC’s total liabilities: $5,000,000
Shortfall: $2,000,000
Insolvency can lead to insolvency proceedings, in which legal action is taken against the insolvent business and its assets may be liquidated to pay off outstanding debts. Before that happens, however, business owners can contact their creditors directly and work on ways to restructure debts so that payments are more manageable. This is in the interest of both business owners and creditors, since creditors want to have their loans repaid, even if that repayment is late.
If an insolvent business is unable to settle their debts through other means, it may need to file for bankruptcy.
Solvent vs Insolvent: The Differences
A solvent company can pass these two tests:
The Cash Flow Test A solvent company can pay debts that are about to fall due, as well as debts that will be due in the near future, either with cash accumulated from operations or cash the business has in the bank. Can yours?
The Balance Sheet Test With this measure, an independent third party assesses the value of all your company’s assets as well as its liabilities. If the amount of the assets falls short compared to the liabilities, then the company has failed the balance sheet test. This indicates that your company will be unable to pay off current debts even if all of the company assets are sold off.
Failing one or both tests means you need to take steps to improve your business’s financial position.
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How to Remedy Insolvency
Moving a business from insolvency to solvency typically entails managing your debt and improving your cash flow.
To reduce your debt, consider listing all of your company’s debts in order of priority, focusing on debts that need to be paid immediately (such as those that could interrupt operations or lead to legal trouble if not paid on time) first. It’s also a good idea to reach out to your creditors to see if you can negotiate better repayment terms.
You might also want to look into refinancing your debt. This involves applying for a new business loan, ideally with more attractive terms, and using it to pay off your old loan. If you have multiple loans, you might consider business debt consolidation. This allows you to combine multiple loans into a new consolidation loan with one easy-to-manage payment. While getting a lower rate is an added perk, the primary purpose of business debt consolidation is to simplify your various loan payments.
In addition to managing debt, you’ll likely also need to find ways to decrease spending. You may be able to do this by cutting out all unnecessary costs and/or finding cheaper suppliers for materials, stocks, and/or insurance.
To further improve cash flow, consider ways to boost your customer base, such as using customer feedback, increasing social media and email marketing, and learning from other businesses.
How to Maintain Solvency
Maintaining solvency is essential for a company’s survival in the long run. That’s why it’s critical that companies regularly analyze their ability to meet both their short- and long-term liabilities. If, at some point, your company’s liabilities become greater than its assets, it’s important to take actions that can increase solvency, such as lowering overhead costs, reducing debt, and increasing cash inflows.
The Takeaway
Solvency is the ability of a company to meet its financial obligations and long-term debt. It’s also defined as the positive net worth of a company. The easiest way to assess a company’s solvency is by checking its owners’ equity on the balance sheet, which is the sum of a company’s assets minus its liabilities.
If your business maintains a positive solvency position, it means it can meet all of its financial obligations and remain operational in the long term. It also means that your company will have access to small business financing opportunities with lower rates and better terms, since banks and other lenders prefer working with solvent businesses.
If you’re seeking financing for your business, SoFi can help. On SoFi’s marketplace, you can shop top providers today to access the capital you need. Find a personalized business financing option today in minutes.
FAQ
How can you tell if a company is solvent?
The quickest way to assess a company’s solvency is to check its owners’ equity on the balance sheet, which is the sum of a company’s assets minus its liabilities. A positive number means the company is solvent. A negative number means the company is insolvent.
Can a business be liquid but not solvent?
Yes. It’s possible for a business to be insolvent (it has more liabilities than assets) but still have sufficient cash flow to cover any short-term liabilities. such as loans, staff wages, bills, and taxes.
Why would a solvent company be liquidated?
There are a variety of reasons that might cause a solvent company to be liquidated. If a firm can pay its long-term obligations, but no longer has a value proposition in the marketplace, then liquidation can make sense. A solvent company might also be liquidated because the owner has chosen to retire or focus on something else.
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