What is solvency in business?

When you’re running a business, a certain amount of debt is normal, particularly in the early days. That said, it’s crucial that you keep an eye on it. 

More specifically, it’s important for you to know when your business is taking on too much debt compared to its actual value, and how to measure it. That’s where solvency comes in. 

In this article, we’ll be talking about how solvency is used in business and why it matters. Specifically, we’ll be covering:

• What is solvency in business?
• Why does solvency matter in business?
• What’s the difference between solvency and liquidity?
• How do you measure solvency?
• How do I improve solvency?

Solvency is a term that describes a business’ ability to pay off it’s long-term financial debts. In other words, it’s the assets of a business compared to the liabilities of the business.

By measuring solvency, businesses can estimate the financial health of their business. If a business doesn’t have enough assets to cover the cost of its liabilities, it’s referred to as insolvent. 

Solvency is often confused with liquidity. And while they’re both important, and similar, there are a few key differences between them. 

While solvency shows your ability to repay long term debt, liquidity shows your ability to repay short and mid-term debt. 

Liquidity only takes assets into account that can be quickly converted into cash (like inventory or actual money) because larger fixed assets (like property and equipment) can’t be sold fast enough to pay off immediate debt.  

While they’re different measurements, solvency and liquidity are often calculated together to get a better overall view of a business’ financial situation. For example, it’s possible for a business to be insolvent (it has more liabilities than assets) but still produce steady levels of income. 

Measuring debt is a crucial part of running a business. It’s necessary to take on a certain amount of debt in order to grow your business, but having too much without the assets to pay it back can quickly drive your business into the ground. 

That’s why solvency is often measured next to liquidity; businesses need to find the right balance between debt, assets, and income.

There are three basic ways to measure the solvency of a business. They’re all ratios that measure different kinds of value against debt:

• Debt-to-asset ratio
• Debt-to-equity ratio
• Debt-to-cash flow ratio

Before we cover these ratios in more detail, it’s important to mention that there are certain events that can affect solvency that might not show up in normal calculations. The events are ones that could affect a business’ ability to produce income. 

For example, a change in legislation or tax codes could have a direct impact on your cash flow or profits. 

Also referred to as “debt ratio”, it compares your assets to your liabilities. 

A lower debt-to-asset ratio shows you’ll always have the money available (through selling assets) to pay back debts, meaning your business will look less risky to potential investors and banks.

Companies with shareholder equity can use this ratio to measure solvency. 

Equity is the total value of a company after all its assets are liquidated and liabilities are paid, so comparing shareholder equity to debt is a good indicator of a company’s financial situation. 

This ratio compares the amount of available cash a business has compared to their long-term liabilities. 

Debt-to-cash flow ratio is useful because it shows how easily a business can repay its debts without having to sell any of its assets. 

Improving solvency comes down to changing those ratios we mentioned earlier. Generally speaking, the best way to do this is by managing your debt and cash flow. 

Some strategies for managing debt include:

• Prioritising your debts.
• Restructuring your debt.
• Negotiating better payment terms.
• Cutting unnecessary costs.

For more detailed information about debt management, try reading our article, “How to manage debt for your small business”.

On top of managing your business debt, you can also improve your cash flow by:

• Increasing your customer base. 
• Increasing the average amount your customers spend. 
• Increasing the number of times a customer makes a purchase. 
• Raising your prices. 

Figuring out solvency ratios requires detailed financial records like cash flow. And keeping financial records is simple with the Countingup app. 

Countingup is currently the only business current account that lets customers view their cash flow in real time. This is because it combines the business current account and accounting software in one app. Other accounting softwares offer the ability to link to bank feeds, but there are data lags and so this information is often not up-to-date. With the Countingup app, you’ll always have the latest, most accurate information possible. 

Alongside other features like automatic expense categorisation, invoicing on the go, receipt capture tools, and tax estimates, you can confidently keep on top of your business finances wherever you are. 

You can also share your bookkeeping with your accountant instantly without worrying about duplication errors, data lags or inaccuracies. Seamless, simple, and straightforward! 

Find out more here.