What is solvency?
A solvent business can pay its debts as they fall due over the long term and has more assets than liabilities. Insolvency usually means failing one or both of these tests:
- Cash flow test: unable to pay debts as they fall due.
- Balance sheet test: liabilities exceed assets.
Solvency vs liquidity
[Liquidity](/glossary/liquidity) looks at the next 12 months. Solvency looks at the long term. A business can be solvent but illiquid (for example, valuable property but no cash), or liquid but heading for insolvency.
Solvency ratios
- Debt-to-equity = Total liabilities ÷ [Equity](/glossary/equity)
- Debt-to-assets = Total liabilities ÷ Total assets
- [Interest coverage](/glossary/interest-coverage-ratio) = EBIT ÷ Interest expense
- Solvency ratio = (Net income + Depreciation) ÷ Total liabilities
Example
A business has total assets of $1.2 million and liabilities of $800,000, so equity is $400,000 and debt-to-equity is 2.0. Whether that is acceptable depends on the industry and the stability of its cash flows.
Why it matters
Directors in many countries have legal duties once a company is insolvent or close to it, including putting creditors' interests first. See also [going concern](/glossary/going-concern) and the [Altman Z-score](/glossary/z-score).