Solvency is defined as a corporation’s ability to meet its long-term fixed expenses. A solvent company will also be able to invest in its own long-term expansion and growth. A solvent company is financially healthy. An insolvent company is financially dead, can no longer operate and is undergoing bankruptcy. Five mathematical ratios are used to determine the solvency of any company, whether they are publicly or privately held, for-profit or non-profit. The information required to figure these solvency ratios is found on the financial statements: the balance sheet, the statement of cash flows and the income statement.
Find the number representing total liabilities and total assets of the company. The total liabilities number needs to be divided by the total assets number. This ratio is called the debt-to-total-assets ratio, which measures the dollar amount of a company’s assets that is financed by creditors. These are debts that must be repaid from the company’s cash reserves at specific times. The higher the percentage of debt-financing the company has, the riskier the company is. Look for companies that have low debt-to-total-assets ratios.
Find the number representing the amount of cash provided by operations, and find at least two years’ worth of current liabilities. The cash provided by operations needs to be divided by the average current liabilities. This number also shows the company’s ability to make enough money to meets its debts and other obligations in the long term.
Subtract capital expenditures and cash dividends from cash provided by operations. This is the way to determine the company’s amount of free cash flow. Free cash flow is a measure of the amount of cash a company has that will allow for investing, payment of debts and its overall liquidity.
Add the company’s net income, interest expense and tax expenses together, and divide the total by the interest-expense number. This will reveal the times-interest-earned ratio, a measure of the company’s ability to meet interest payments when they are due.
Divide cash provided by operations by capital expenditures to find the capital-expenditure ratio. This is a relative measure of cash provided by operations compared with the amount of cash used to buy productive assets. This number reveals the company’s asset-investing capabilities. The higher, the better.
- Investopedia: Solvency
- Financial Accounting: Tools for Business Decision Making, 2nd Edition; Paul Kimmel, Jerry Weygandt and Donald Kieso, 2001 (Book)