What is solvency?

Solvency is a company's ability to meet its long-term debts and financial obligations and continue operating into the future. A simple solvency check uses the balance sheet: assets minus liabilities equals shareholders’ equity. If that difference is positive, the company is solvent on a book-value basis.

Solvency in business operations

  • Shareholders’ equity (assets − liabilities) provides a quick view of long-term financial health.
  • Negative shareholders’ equity generally indicates insolvency and can signal no remaining book value if the business were liquidated.
  • Negative equity is more common in early-stage companies; mature firms typically move toward positive equity.
  • Solvency risk can increase from events such as expiring patents, adverse regulatory changes, large litigation judgments, or other shocks to future cash flows.
  • Solvency differs from liquidity: a firm can be insolvent yet maintain short-term cash flow and operate for a period if it has sufficient liquidity.

Key solvency ratios and what they show

Use ratios to analyze different aspects of solvency and a firm’s ability to service long-term obligations:

  • Solvency ratio: (Net income + Depreciation & Amortization) / Total liabilities
    — Measures the ability to cover liabilities with earnings and non-cash charges.

  • Interest coverage ratio: Operating income / Interest expense
    — Shows how easily a company can pay interest on outstanding debt; higher is better.

  • Debt-to-assets ratio: Total debt / Total assets
    — Indicates how much of the asset base is financed by debt.

Other useful measures:
- Debt-to-equity
- Debt-to-capital
- Debt-to-tangible-net-worth
- Total liabilities to equity
- Total assets to equity
- Debt-to-EBITDA

Note: “Healthy” ratio levels vary by industry—compare companies to appropriate industry benchmarks.

Solvency vs. liquidity

  • Solvency = ability to meet long-term obligations.
  • Liquidity = ability to meet short-term obligations (typically within one year).

Common liquidity measures:
- Working capital = Current assets − Current liabilities
- Current ratio = Current assets / Current liabilities
- Quick ratio = (Cash + Marketable securities + Receivables) / Current liabilities
- Working capital turnover = Sales / Average working capital

A business can be insolvent yet survive temporarily if it has adequate liquidity. Conversely, a business without liquidity can fail quickly even if solvent on paper.

FAQs

  • How is solvency determined?
    The basic test is whether assets exceed liabilities (positive shareholders’ equity). Ratios like the solvency ratio and interest coverage provide deeper insight.

  • Are solvency ratios the same for every company?
    No. Acceptable levels depend on industry, business model and capital structure.

  • Can a company survive if it is insolvent?
    It can for a time if it has sufficient liquidity and cash flow, but persistent insolvency raises the risk of restructuring, creditor action, or closure.

Bottom line

Solvency is a key indicator of long-term financial health. Start with shareholders’ equity to get a quick read, then use solvency and coverage ratios for a deeper assessment. Always consider liquidity alongside solvency and benchmark ratios against industry standards for a complete view of financial strength.