Business owners tend to think their No. 1 priority is to make a profit. That end, however, can lead to using some particularly short term-minded means, such as using large amounts of debt to grow faster. That short-term thinking can lead to a major long-term problem as the business erodes its ability to stay solvent should those profits and the company's liquidity dry up. This is why solvency should be on the mind of every business owner and stakeholder.
What is solvency?Solvency refers to a company's ability to meet its long-term financial obligations. Basically, it's a company's financial staying power. Once solvency is lost that company is said to be insolvent, which leaves it with no other choice but to enter bankruptcy in order to liquidate.
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Solvency differs from liquidity, which is a company's ability to meet its short-term obligations. A company can enter bankruptcy because its liquidity has run dry, but it could still be solvent once the rough patch has passed and it can reemerge even stronger. An example ofan illiquid yet solvent business is a company that can still meet its interest obligations, but because of a banking or financial crisis, or lack of investor support due to the amount of debt, it can't borrow money to refinance debt that has come due.
How to determine a company's solvency?There are a number of ways to analyze a company's solvency. One key test is to look at the solvency ratio, which measures a company's ability to meet its debt and other obligations. It is calculated by adding net income (or after-tax profit) to depreciation and then dividing that by a company's short-term plus long-term liabilities. The lower the solvency ratio the more likely a company will default on its debt in the future.
Another applicable test is to check a company's interest coverage ratio. This divides operating income by interest expense anddemonstrates a company's ability to pay the interest on its debt, which provides a good picture of its ability to remain solvent. A third common ratio is the debt-to-equity ratio, which divides a company's debt by its equity and shows the amount of debt the company has accrued. The key when looking at a company's solvency is to test a number of different debt ratios to get a fuller picture of the business's long-term financial well-being.
What happens when solvency is lost?When a company can no longer meet its financial obligation that company has become insolvent. This often leads to insolvency proceedings in which legal action is taken to liquidate a company's assets to pay down its debt.
One of the most famous instances of lost solvency is Enron. The energy trading giant once posted more than $100 billion in annual revenue, but it also amassed more than $38 billion in debt. That debt led to the company's collapse after it became embroiled in an accounting scandal. Its vast debt left it insolvent and with no choice but to file for bankruptcy to liquidate its assets. That liquidation process took several years, but once complete all vestiges of Enron ceased to exist.
Investor takeawayWhen a company's liquidity runs out it's still possible for that business to survive by being reorganized in bankruptcy. However, once a company is no longer solvent it is game over as all assets will be liquidated and it will cease to exist. That's why solvency is vitally important to a business and its stakeholders -- it's the difference between survival and elimination when a company goes through a really rough patch.
The article How Solvency Impacts a Business's Ability to Survive originally appeared on Fool.com.
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