Definition: Solvency is a condition of a person or firm when it has enough assets to discharge its liabilities. The term commonly applies to companies that are assumed to be financially able to meet its debts.
What Does Solvent Mean in Business?
Being solvent is a signal of financial health. Companies work constantly to maintain or even increase solvency ratios since insolvency can bring severe problems. Formally speaking, it is necessary to review the company’s Balance Sheet and then to perform some easy calculations to assess a firm’s solvency. Usually, this procedure involves the calculation of a solvency ratio that shows if a company is sufficiently solvent or not. A common way to calculate this is to subtract current liabilities from currents assets. The assets must be greater to guarantee that the company is solvent to meet its short-term debts and obligations, like payroll, suppliers, and others.
In other cases, the calculation can be more strict, because it includes all assets and liabilities. If a company shows that assets are greater than liabilities then it is possible to say that there is long-term solvency. This condition can also be seen as a positive factor to guarantee a business sustainability over time. Strategies to improve solvency are reduction of liabilities, increase of assets or a combination of both.
Example
Bethan Glass Inc. is a manufacturing firm that markets different types of glass products. It sells to large constructions companies and other companies that use glass as raw material. The firm wants to expand the manufacturing facilities with the purpose of producing new varieties demanded by the market.
This investment is estimated in US$320,000 so Bethan Glass Inc. needs a long-term loan. Each bank has its own particular requirements but all banks denied the loan because their calculations resulted in a long-term solvency ratio under 1. The company therefore implemented a plan to increase solvency and three years later it was able to get the loan.
