How it works (Example):
Solvency measures a company's ability to meet its financial obligations.
Short-term solvency is often measured by the current ratio, which is calculated by dividing current assets by current liabilities.
Longer-term solvency is evaluated using the solvency ratio, which divides the company’s net worth by its total assets.
A business can be insolvent but still profitable. For example, a company may borrow money to expand its operations and be unable to immediately repay its debt from existing assets. In this instance, the lender assumes cash flows will increase because of the business expansion and enable the company to comfortably meet payment obligations in the future.
Why it Matters:
A company's solvency determines its ability to service debts and achieve long-term growth and profitability. A business that is completely insolvent is unable to pay its debts and will be forced into bankruptcy. Investors should examine all the financial statements of a company to make certain the business is solvent as well as profitable.