Meaning and definition of Solvency
In finance, solvency refers to the extent to which the current assets of a business entity exceed its current liabilities. Solvency can also be defined as the ability of a business to congregate its long term fixed expenses in addition to accomplishment of long term growth and expansion. As stated by Investopedia, the better solvency level of a company indicates it being financially healthy. When a company is insolvent, it implies that it is not capable oof operating any longer and is going through bankruptcy.
Calculating solvency of a company
Generally, the solvency of a company is determined through five mathematical ratios. The info needed to calculate these solvency ratios are available on the financial statements – the cash flow statement, income statement, and the balance sheet.
However, there are certain instructions which can be followed to determine the solvency of a company. These are:
- Calculate the total assets and total liabilities of the company. The total liabilities amount is then divided by the total assets amount. This ratio is known as the debt-to-total assets ratio, which assesses the dollar amount of the assets of a company which are financed by creditors. These are debts which are obligatory to be paid back from the cash reserves of the company at particular times. A higher percentage of debt-financing represents a riskier company.
- Calculate the amount of cash provided by operations, and find a minimum of two years’ worth of current liabilities. This cash from operations is then divided by the average current liabilities. This number also represents the company’s ability to earn enough money to congregate its debts and other liabilities in the long run.
- Sum up the net income of the company, tax expense, and interest expense altogether, and then divide this sum by the interest-expense number. This divulges the times-interest-earned ratio, a quantification of the company’s capability to meet up interest payments when due.
- Subtract the capital expenditures and cash dividends from cash from operations. This is the method of determining the amount of free cash flow of the company. Free cash flow is a quantification of the amount of cash possessed by a company which allows for investing, debt payments, and overall liquidity.