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Solvency: Definition, Understanding and Difference

Sarmaaya Desk
Sarmaaya Content Team

Key Takeaways:

  1. Solvency is the company’s ability to meet its long-term debt and other financial obligations.
  2. If the company’s value of its realizable assets is greater than its liabilities, it is considered to be solvent.
  3. It helps analysts understand the company’s ability to sustain itself.

What is Solvency?

The ability of a company to meet its long-term debt and other financial obligations is its solvency. It helps measure the financial health of the company by evaluating the company’s ability to manage its operations in the near future.

 

Understanding

To understand Solvency, analysts must look at the balance sheet and cash flow statements of the company.

A balance sheet summarizes the company’s assets and its liabilities. If the company’s realizable value of the assets is greater than its liabilities, it is considered to be solvent. If the realizable value of the assets is less than its liabilities, then the company is considered to be insolvent.

Cash flow statement focuses on the company’s ability to meet its short-term debts and obligations. It analyzes the company’s ability to pay its debts and have cash readily available to meet other financial obligations. As a result, the cash flow statements are also a good indication of the company’s solvency.

Cash flow statements also provide insight into the company’s history of paying debts. If there is a lot of debt outstanding, then that is an indication of insolvency. If it shows regular payments being made to reduce the liability of debt, then this indicates solvency. This information is further an indication of the company’s ability to pay off debts that are in the foreseeable future.

Solvency analysis can help uncover information regarding financial losses, inability to pay off debt or lack of proper funding and non-payment of taxes and fees – all of which are an indication of bad management and thus, insolvency. Solvency will help analysts understand the company’s ability to sustain itself and its potential for growth because any business planning to expand should aim to remain solvent.

 

How is Solvency different from liquidity?

Solvency indicates a company’s ability to meet all of its financial obligations which includes current and non-current liabilities. Liquidity on the other hand only talks about the company’s ability to meet only short-term obligations. Therefore, analysts should check the company’s liquidity levels, to see if it has a negative book value.

 




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