# Understanding Solvency: Definition and Key Solvency Ratios Explained

## What Is Solvency?

Solvency refers to a company's capacity to fulfill long-term debts and financial commitments, reflecting its financial health and operational longevity. A quick solvency check involves examining [shareholders’ equity](https://www.investopedia.com/terms/s/shareholdersequity.asp), derived from the difference between assets and liabilities on the balance sheet.

### Key Takeaways

*   Solvency is crucial for a company to demonstrate the ability to meet its long-term debts and continue operations into the future.
*   Analyzing a company's shareholders' equity is a quick method to gauge solvency, representing assets minus liabilities.
*   Solvency ratios, including the debt-to-assets and interest coverage ratios, help assess a firm's financial health and ability to service debt.
*   While solvency measures long-term financial stability, liquidity focuses on a company's capacity to handle short-term obligations.
*   Solvency ratios differ among industries, so comparing a company's ratios with industry benchmarks is vital for accurate analysis.

![Solvency](https://www.investopedia.com/thmb/kSG0AsDCitxna2Ce5B0UxybVc4U=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/solvency.asp_Final-57519eddeb1c4f68b51df82638802cef.png)

*— Investopedia / Dennis Madamba*

## Understanding Solvency in Business Operations

Solvency exists if a business or person can [pay their debts](https://www.investopedia.com/terms/w/whitewashresolution.asp). For this reason, the quickest assessment of a company’s solvency is its assets minus [liabilities](https://www.investopedia.com/terms/t/total-liabilities.asp), which equal its shareholders’ equity. There are also solvency ratios, which can spotlight certain areas of solvency for deeper analysis.

Many companies have negative shareholders’ equity, which is a sign of insolvency. Negative shareholders’ equity insinuates that a company has no [book value](https://www.investopedia.com/terms/b/bookvalue.asp), and this could even lead to personal losses for small business owners if not protected by limited liability terms if a company must close. In essence, if a company was required to immediately close down, it would need to liquidate all of its assets and pay off all of its liabilities, leaving only the shareholders’ equity as a remaining value.

> **Fast Fact**
>
> Shareholders' equity on the balance sheet quickly reveals solvency and financial health.

Carrying negative shareholders’ equity on the [balance sheet](https://www.investopedia.com/terms/b/balancesheet.asp) is usually only common for newly developing private companies, startups, or recently offered public companies. As a company matures, its solvency position typically improves.

Certain events can raise solvency risks, even for strong companies. In the case of business, the pending expiration of a [patent](https://www.investopedia.com/terms/p/patent.asp) can pose risks to solvency, as it will allow competitors to produce the product in question, and it results in a loss of associated royalty payments. Further, changes in certain regulations that directly impact a company’s ability to continue business operations can pose an additional risk. Both businesses and individuals may also experience solvency issues should a large judgment be ordered against them after a lawsuit.

When studying solvency, it is also important to be aware of certain measures used for managing liquidity. Solvency and liquidity are two different things, but it is often wise to analyze them together, particularly when a company is insolvent. A company can be insolvent and still produce regular cash flow as well as steady levels of working capital.

## Analyzing Solvency With Key Ratios

Subtracting liabilities from assets is the easiest way to see a company's solvency. The [solvency ratio](https://www.investopedia.com/terms/s/solvencyratio.asp) calculates net income + depreciation and amortization / total liabilities. This ratio is commonly used first when building out a solvency analysis.

There are also other ratios that can help to more deeply analyze a company's solvency. The interest coverage ratio divides operating income by interest expense to show a company's ability to pay the interest on its debt. A higher interest coverage ratio indicates greater solvency. The [debt-to-assets ratio](https://www.investopedia.com/terms/t/totaldebttototalassets.asp) divides a company's debt by the value of its assets to provide indications of capital structure and solvency health. 

Other ratios that may be analyzed when considering solvency include:

*   Debt to equity
*   Debt to capital
*   Debt to tangible net worth
*   Total liabilities to equity
*   Total assets to equity
*   Debt to EBITDA

Solvency ratios differ by industry, so know what's considered a good level for a company before judging its ratios. Ratios that suggest lower solvency than the industry average could raise a flag or suggest financial problems on the horizon.

#### Liquidity Vs. Solvency

## Comparing Solvency and Liquidity: Key Differences

Solvency is about meeting all financial obligations, while [liquidity](https://www.investopedia.com/articles/investing/100313/financial-analysis-solvency-vs-liquidity-ratios.asp) is about handling short-term ones. This is why it can be especially important to check a company’s liquidity levels if it has a negative book value.

One of the easiest and quickest ways to check on liquidity is by subtracting short-term liabilities from short-term assets. This is also the calculation for [working capital](https://www.investopedia.com/terms/w/workingcapital.asp), which shows how much money a company has readily available to pay its upcoming bills.

Short-term assets and liabilities are those due within a year. For example, cash and equivalents is a common short-term asset. Short-term accounts payable is a common short-term liability.

A company can survive with insolvency for a reasonable time period, but a company cannot survive without liquidity. Some interesting [ratios](https://www.investopedia.com/terms/l/liquidityratios.asp) that can be helpful in more deeply assessing liquidity can include:

*   Quick ratio
*   Current ratio
*   Working capital turnover

## How Is Solvency Determined?

There are several ways to figure a company's solvency ratio, but one of the most basic formulas is to subtract their liabilities from their assets. If there is still value after the liabilities have been subtracted, the company is considered solvent.

## Are Solvency Ratios the Same for Every Company?

No. Solvency ratios vary from industry to industry. While companies should always strive to have more assets than liabilities, the margin for their surplus can change depending on their business.

## Can a Company Survive If They Are Insolvent?

Some companies can survive for a time while being insolvent. Since their assets and liabilities tend to be long-term metrics, they may be able to operate the same as if they were solvent as long as they have liquidity. Liquidity is the capital that a company has to operate their business.

## The Bottom Line

Solvency is crucial for assessing a company's financial health, reflecting its ability to meet long-term obligations. A quick check of a company's balance sheet, specifically the shareholders' equity, can provide an immediate view of solvency. Solvency ratios, such as the solvency ratio and interest coverage ratio, offer deeper insights into a company's ability to sustain operations. However, solvency should be evaluated alongside liquidity to get a comprehensive picture; a company may remain operational despite insolvency if it maintains sufficient liquidity. Investors should also account for industry-specific solvency standards when analyzing financial statements to ensure accurate assessments.