In this podcast episode, we discuss the use of a separate budget to act as a benchmark to track a company’s solvency. Key points made are noted below.

How to Spot a Solvency Problem

The topic of this episode comes from a listener, and it is – how to provide advance warning of a solvency problem. The listener is from Australia, and his request is based on the Corporations Act of 2001, which states that the directors of a corporation must pass a solvency resolution within two months of each review date for the business. That resolution has to state whether – and I’m quoting here – the directors believe there’re reasonable grounds to believe that the company will be able to pay its debts as and when they become due and payable.

And I couldn’t help noticing that this part of the Act also contains a reference to the Australian Criminal Code, so there must be some fairly severe penalties for getting this wrong.

So in essence, the request is to figure out a way for the accounting department, which deals with historical information, to come up with a system to detect solvency problems in the future. There’s an obvious disconnect right there, since the information needed is forward-looking, but there is one way to do this.

The Solvency Budget

Besides collecting and reporting on historical information, the accounting department is also in charge of the annual budget. As many of us know, the budgets that management comes up with can be a long way away from reality. Sometimes, we get to the end of the year and compare budget to actual, and they’re not even close.

But there is a way to adjust the budget concept so that it becomes a warning flag for solvency issues. To do this, the accounting department comes up with its own budget for the company – it can ignore whatever management created. Let’s call this the solvency budget. The only intent behind this budget is to present a reasonably solvent financial structure for the company. We can then compare actual results to the solvency budget to see how the business is doing. And better yet, we track this actual to budget comparison on a trend line, to see if the solvency situation is trending better or worse.

Solvency problems tend to be like a slow-moving train wreck, where you can see them coming a few months in advance as all of the financial ratios start trending worse and worse. And then the company goes bankrupt, just like all of the financial indicators showed a few months earlier. Which is why tracking these variances on a trend line is such a good idea.

So, how do we derive a solvency budget? One good starting point is any covenants attached to company loans. These covenants might require that the company maintain a two-to-one current ratio, or always have a million dollars in cash in the bank. These covenants are set by the lender, because the lender considers these thresholds to be the minimum acceptable level for a solvent borrower. So if that’s how the lender defines solvency, then that’s good enough for me.

Or, you can go back through the company’s historical records to see how its liquidity ratios looked during a good year. That means deriving its current ratio or quick ratio, and maybe its debt service coverage ratio, based on the financial structure the company had back then. These are good ratios to use, because they relate to the company’s own operations, not some theoretical values derived by an outside analyst about what constitutes solvency. In short, these are ratios that the business has proven that it can maintain during solvent times.

Next, build your own solvency financials, using those ratios. For the income statement, I would create your best estimate of what the company is actually going to do, which could be a lot lower than what management is guesstimating. And set up the balance sheet based on those solvency ratios. I would do this by month for just the next three months. The reason for going so short is that even the best accountant can’t project very far into the future, so don’t try. Just keep rolling forward the three-month forecast, always building into it your minimum acceptable levels for solvency ratios.

Rather than loading this budget into the accounting software, I would just keep it on an electronic spreadsheet. There are going to be so many changes to the forecast that it’s just easier to make spreadsheet adjustments. Most accounting software is a bit kludgy when you want to keep updating the budget.

How to Report Solvency Issues

So, you’ve developed a solvency budget – what are you going to do with it? I would set up a report for management, to go over with them in person once a month. In that report, the main focus is on how close the company is getting to those minimum solvency threshold values, and especially when there’s a negative trend. So if there’s a loan covenant that says the loan can be pulled if the current ratio drops below two-to-one, it would be a good idea to start warning management months in advance when the ratio drops from three-to-one, to 2.5-to-one, and so one. This emphasis on trends should provide management with enough time to take corrective action.

When Solvency Reporting Does Not Work

And now, for the downside. This solvency budget approach only works when a business is stuck in a long, slow decline. It doesn’t work at all for sudden liquidity problems, like having a big customer go bankrupt and stick you with a huge bad debt.

It’s also not all that useful when the business has a lot of ready financing available, which might be the case with a hot new startup that has lots of backers. In these cases, if the solvency ratios look bad, who cares? The investors just dump in more money. But for the bulk of businesses – those that have been around a while and don’t have wealthy backers – a solvency budget might be a good way to keep things on track.