As a business owner, one of your greatest concerns that you face is whether or not your business is going to survive. Many businesses are in debt for a multiple of reasons: from starting a business, expanding a business, or developing a new product.
But how do you know, as a business owner, that you are solvent?
The solvency ratio is a means for a business owner can use to help them measure the business’ ability to meet its debt and other obligations. The solvency ratio indicates whether the business has sufficient cash flow to meet its short term or long term liabilities.
The ratio is:
Solvency Ratio - Net Income (or after-tax profit) + Depreciation
Short Term + Long Term Liabilities
The solvency ratio should exceed a ratio higher than 20%. If the company’s ratio exceeds 20%, the business is considered to be financially sound.
An important thing to note is that measuring cash flow rather than net income is a better determinant of solvency, especially for companies that incur large amounts of depreciation for their assets but have low levels of actual profitability. Similarly, assessing a company’s ability to meet all its obligations provides a more accurate picture of solvency. A company may have a low debt amount, but if its cash management practices are poor and accounts payable is surging. As a result, its solvency position may not be as solid as would be indicated by measures that include only debt.
A final thought: lenders looking through a company’s financial statement will usually use the solvency ratio as a determinant for creditworthiness.
Disclaimer: This blog is for information purposes only and is not intended to provide investing, accounting, tax or legal advice and should not be relied upon.