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

Here are several scenarios in which the solvency of a business could be threatened:

Excessive debt load. A manufacturing company takes on a large loan to expand its operations, expecting future revenue growth to cover repayment. However, due to a slowdown in demand, sales decline, and the company struggles to meet its interest and principal payments. As debt payments consume most of its cash flow, the company risks insolvency and potential bankruptcy if it cannot restructure its obligations.
Declining revenue without expense adjustments. A retail chain experiences a drop in sales due to changing consumer preferences and increased competition. Despite lower revenue, the company continues operating with high fixed costs, such as rent, salaries, and inventory expenses. Over time, the inability to cut costs leads to negative cash flow, draining reserves and pushing the company toward insolvency.
Legal liabilities. A pharmaceutical company faces multiple lawsuits over a defective drug, leading to massive legal settlements and regulatory fines. These unexpected expenses significantly impact its financial position, depleting cash reserves and forcing it to borrow at high-interest rates. If the company cannot recover through new product sales or cost-cutting, it may become insolvent.
Supply chain disruptions. An electronics manufacturer relies on key components from overseas suppliers, but a geopolitical crisis disrupts shipments. With production halted and no alternative suppliers in place, the company cannot fulfill orders, leading to lost sales and revenue. If the disruption continues for an extended period, the business may struggle to pay its debts and become insolvent.