Assets are the things businesses own, and liabilities are what businesses owe. This is important because every business has problems with cash flow occasionally, especially when starting out. If a business has too many bills to pay and not enough assets to pay those bills, it will not survive.
Solvency on the Balance Sheet
Solvency relates directly to a business’s balance sheet, which shows the relationship of assets to liabilities and equity. The traditional accounting equation is that Assets equal Liabilities plus Owner Equity. The two sides must balance since every asset must have been purchased either with debt (a liability) or the owner’s capital (equity).
Solvency Measures or Ratios
Solvency often is measured as a ratio of assets to liabilities. For example, are there enough assets to pay the bills? In these ratios, the best way to measure solvency is to include all liabilities: accounts payable, taxes payable, loans payable, leases payable, and anything else the business owes. There are two ratios that measure solvency.
Current Ratio
The current ratio is the total current assets divided by total current liabilities. The current assets are cash, accounts receivable, inventory, and prepaid expenses. Other long-term assets like equipment aren’t considered in this ratio because it takes too long to sell them to get money to pay the bills, and they won’t sell for full value.
Quick Ratio
The quick ratio uses only cash and accounts receivable, as these assets are the only ones that can be used to pay off debts quickly, in the case of an emergency cash need. The quick ratio is a 1-to-1 ratio, meaning cash and accounts receivable must equal the amount of debt. This, as you can imagine, is a more difficult ratio to achieve.
Solvency, Liquidity, and Viability
Solvency often is confused with liquidity, but it is not the same thing. Liquidity is a short-term measure of a business, that looks at how quickly a business can sell its assets for cash. Solvency is a long-term measure. Solvency also is confused with viability. Viability is a business’s ability to be profitable over a long period of time. Businesses with a track record of consistently turning profits year after year have viability. This adds to the overall value of a business because of the expectation that it can continue to turn profits moving forward.
