Solvency vs Liquidity: What is Financial Solvency?

Solvency vs Liquidity: What is Financial Solvency?

Solvency vs Liquidity: What is Financial Solvency?

It’s a pretty well-accepted fact that a lot of businesses don’t make it past their second birthday and the average lifespan of a small business is only 8-½ years. Understanding that, it makes a lot of sense for many small business owners to ask, “Is my business solvent?” or “What is financial solvency?” It also makes sense for a small business owner to wonder, “What’s the difference between financial solvency and liquidity?”

What is Financial Solvency?

A business is solvent if it’s able to meet its long-term debts. Basically, solvency is a metric that indicates whether or not a business has the ability to service debt and meet it’s other financial obligations. This is one of the things a lender is looking at when it considers your cash flow and revenues. They are trying to determine if your business has the financial wherewithal to repay a loan—is your business solvent?

What is Liquidity?

Liquidity is related to solvency, but they are not the same thing and are sometimes confused. Liquidity indicates if your company has the liquid assets it needs to meet its financial obligations on time. Liquid assets are any asset that can be converted into cash quickly to pay a debt or meet other needs that require cash. Equipment you can sell, stocks, bonds or other similar assets that can be sold (like a luxury car) would all be considered liquid assets. If, they can be sold quickly to generate cash.

If your business has sufficient Accounts Receivable, for example, to pay all your bills along with meeting your other operational expenses, your business would be considered liquid. If you run out of cash flow every month and can’t meet all your financial obligations, you would not have achieved liquidity.

If you’re thinking there’s a relationship between solvency and liquidity, you’d be right. 

How Do You Measure Solvency?

It’s time to put on your accounting hat, or seek the advice of someone who wears one all the time. There are a few ratios (or formulas) that will help you determine if your business is solvent or not. The solvency ratio is a metric a business lender will likely use to determine your ability to service debt. The formula looks like this:

Net After-Tax Income + Non-Cash Expenses /Short-Term Liabilities + Long-Term Liabilities

Calculating the ratio is pretty simple division, but identifying the right income and liability numbers can be confusing if you’re not used to thinking about your business this way. All of this information should be contained in your financial reports like your income statement, cash flow statement, and your financial statement—provided you are on top of your bookkeeping. Your bookkeeper or accountant can certainly help you decipher your financial reports to make the calculation.

The higher the ratio of Income to Liabilities the better. For example, a 3:1 ratio would be better than a 1:1 ratio and anything below 1:1 would be an indication that your business is not solvent. A 3:1 ratio would tell a lender, for example, that your business is more likely to make periodic payments than a ratio of 1:1. A ratio of less than 1:1 would likely lead to a loan application rejection.

Are There Other Solvency Ratios?

Yes, although the solvency ratio mentioned above is the place to start. These additional ratios will give you a deeper dive into the financial health of your business and help you understand where you might have specific issues to address. Unless you really like diving into all these numbers, this is another place you’ll want to consult with your accountant, but here is a list of other financial metrics you should investigate that will help you evaluate your business.

  • Interest Coverage Ratio
  • Debt-to-Assets Ratio
  • Debt-to-Equity Ratio
  • Debt-to-Capital Ratio
  • Debt-to-Tangible-Net-Worth Ratio
  • Total Liabilities-to-Equity Ratio
  • Total Assets-to-Liabilities Ratio
  • Debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization)

Solvency vs. Liquidity

Solvency and liquidity fit together hand-in-glove when determining if your company has the ability to service debt and should be considered together if you’re anticipating a small business loan. Solvency represents your company’s ability to meet all its financial obligations, but your liquidity addresses your business’ ability to meet its short-term obligations, like your business’ ability to make periodic loan payments. This is why many lenders want access to your business bank account. They want to determine in addition to solvency, if you have the cash flow, or the liquidity, you will need to make each and every periodic payment.

If your solvency ratio is lower than you’d like, it’s possible to stay afloat for a time, but if your cash flow (liquidity) is struggling, it’s very difficult for a business to survive.

Data Informs Loan Decisions

When lenders consider your small business loan application they are looking at the financial information like your solvency ratio and your liquidity to make those decisions. You should too.

If you’re unsure where to start, reach out to your accountant or other trusted financial advisor and take a look at what your financial metrics are saying about your business. It will help you determine whether or not a business loan makes sense for your business and will help you decide where to look, how much money to borrow, and what type of loan payment makes sense.

Having this data at your fingertips might not guarantee you’ll get the small business loan you’re looking for, but it will give you options you might not otherwise have access to like the best business credit card offers or other business financing. At the very least, it will help move your application up to the top of the pile.

This article was originally written on September 24, 2020.

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