What is Solvency?

Solvency is the ability of an organization to pay for its long-term obligations in a timely manner. If it cannot marshal the resources to do so, then an entity cannot continue in business, and will likely be sold or liquidated. Solvency is a core concept for lenders and creditors, who use financial ratios and other financial information to determine whether a prospective borrower has the resources to pay for its obligations.

When the management of a company is deciding whether to finance operations with additional debt or equity, the risk of insolvency is one of its key considerations. When a business operates in a low-profit environment where monthly results are highly variable, it is at greater risk of insolvency, and so should be more inclined to finance operations with additional equity.

How to Measure Solvency

The debt to equity ratio and the times interest earned ratio are among the more commonly used metrics for making a determination regarding solvency. Another indicator is the presence of negative equity on a firm’s balance sheet, since it implies that the entity has no book value.

Debt to Equity Ratio

The debt to equity ratio measures the riskiness of a company's financial structure by comparing its total debt to its total equity. To calculate the debt to equity ratio, simply divide total debt by total equity. In this calculation, the debt figure should include the residual obligation amount of all leases. The formula is as follows:

(Long-term debt + Short-term debt + Leases) ÷ Equity = Debt to equity ratio

Times Interest Earned Ratio

The times interest earned ratio measures the ability of an organization to pay its debt obligations. These obligations may include both long-term and short-term debt, lines of credit, notes payable, and bond obligations. The ratio is calculated by comparing the earnings of a business that are available for use in paying down the interest expense on debt, divided by the amount of interest expense. The formula is:

EBIT ÷ Interest expense = Times interest earned

Solvency Scenarios

Solvency can be considered difficult to maintain based on a non financial event. For example, a company that relies on an income stream from patent royalties may be at risk of insolvency once the patent expires. Continued solvency can also be a concern when a business loses a lawsuit from which the damages are considered to be significant, or regulatory approval is not obtained for a business venture.