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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 assets of a business are greater than the liabilities of the business. 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 a 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 produce steady levels of income.
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. For example, let’s look at XYZ company…XYZ Company’s assets: $4,000,000 XYZ Company’s liabilities: $2,000,000 XYZ Company’s owners’ equity: $2,000,000 In this quick example, the firm 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.
What Is Insolvency?
Taking out small business loans is part of doing business and allows business owners to expedite growth. If a company takes on too much debt too quickly, however, it can lead to insolvency – a state in which it can no longer pay off its debts. 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, it could lead to a personal loss for the owners if they are not protected by limited liability terms. The business would need to liquidate all of its assets and pay off all of its liabilities, leaving only the owner’s equity as a remaining value.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.Recommended: What Happens if You Fail to Repay a Business Loan?
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. For example…XYZ Company's total assets: $3,000,000 XYZ Company’s total liabilities: $5,000,000 Shortfall: $2,000,000 Insolvency can lead to bankruptcy. It can also 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.
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 the 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.
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. Also reach out to your creditors to see if you can negotiate better repayment terms. You might also want to look into refinancing your debt, which involves comparing small business loan rates and then combining different loans into one, more affordable, one. In addition to managing debt, you’ll 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, look for 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 their long-term liabilities, including factors like interest. If, at some point, your company’s liabilities become greater than your 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 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.
3 Small Business Loan Tips
Online lenders generally offer fast application reviews and quick access to cash. Conveniently, you can compare small business loans by filling out one application on Lantern by SoFi.
If you are launching a new business or your business is young, lenders will consider your personal credit score. Eventually, though, you’ll want to establish your business credit.
If you need to borrow money to cover seasonal cash flow fluctuations, a business line of credit, rather than a term loan, provides the flexibility you likely need.
Frequently Asked Questions
How can you tell if a company is solvent?
Can a business be liquid but not solvent?
Why would a solvent company be liquidated?
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About the Author
Mike Zaccardi
Mike Zaccardi, CFA, CMT, is a finance expert and writer specializing in investments, markets, personal finance, and retirement planning. He enjoys putting a narrative to complex financial data and concepts; analyzing stock market sectors, ETFs, economic data, and broad market conditions; and producing snackable content for various audiences.
