Financial solvency is the ability of a company to meet all its obligations regardless of their term. Sometimes it is referred to as liquidity, but this is only one of the degrees of solvency. It is said that a company has solvency when it is capable of liquidating the liabilities incurred upon maturity and it shows that it will be able to maintain this situation in the future.
Definition of solvency
Solvency. Ability to meet all financial commitments in the long term. The solvency analysis should include all commitments (short and long term) and all resources (short and long term). Creditworthiness is possibly the most deeply rooted area of assessment in the analysis. This is due to the fact that a good part of what is known today as financial analysis began and developed in the banking field of credit risk analysis. Traditionally, banks have been interested primarily in the solvency of their debtors and only secondarily in their liquidity and profitability. Solvency analysis has evolved quite a bit over time.Another way of evaluating solvency is the background analysis (which, unlike the previous one, presupposes the reliability of the accounting information contained in the balance sheet). In it, it is the debtor's net worth that guarantees solvency. In the recent past, analysts' attention has shifted from fund data (balance) to flow data (in principle, collections and payments). Certainly, if financial commitments are to be satisfied with money, the ability of the company to generate a sufficient flow of cash must be the fundamental basis for qualifying its solvency. (Mora, p.209)collections and payments). Certainly, if financial commitments are to be satisfied with money, the ability of the company to generate a sufficient flow of cash must be the fundamental basis for qualifying its solvency. (Mora, p.209)collections and payments). Certainly, if financial commitments are to be satisfied with money, the ability of the company to generate a sufficient flow of cash must be the fundamental basis for qualifying its solvency. (Mora, p.209)
Degrees of solvency
- Final solvency. Difference between total assets and payable liabilities, it is called final because it would be the one used in the case of a business liquidation. Through it, it is measured if the value of the assets of the asset back all of the debts incurred. Current solvency (Liquidity). It consists of the relationship between current assets and current liabilities, evidencing the ability to service debts in the short term without interference to the production process or the financial structure of the company.
Difference between solvency and liquidity
| Solvency is: | Liquidity is: |
| Have sufficient assets and resources to support the debts incurred, even when these assets are different from cash. | Have the necessary cash, at the right time, to allow payment of the commitments made. |
In other words, liquidity is complying with the commitments and solvency is having with what to pay those commitments, to have liquidity it is necessary to have solvency previously. From the above, it is clear that solvency is the possession of abundant assets to settle debts but if there is no facility to convert those assets into money or cash to make payments then there is no liquidity.
Every business that has liquidity is solvent, but not every solvent business is necessarily liquid. Miguel Miranda
The easier it is to convert the resources of the assets that the company owns into money, the greater the ability to pay to meet its debts and commitments.
However, it should be clarified that liquidity depends on two factors:
- The time required to convert the assets into money The uncertainty in time and the realization value of the assets in money.
How liquidity is measured
The three basic measures of liquidity are:
- Net Working Capital Rapid Test Reason (Acid Test)
Net working capital
Although it is not actually an index, it is commonly used to measure the overall liquidity of a company. It is calculated as follows:
Net Working Capital = Current Assets - Current Liabilities
Liquidity ratio
The higher this coefficient, the greater the company's ability to meet its short-term obligations. Measures the ability of the company to meet its short-term obligations.
Liquidity ratio = Current Assets / Current Liabilities
Quick test reason
It is calculated by subtracting inventories from current assets and dividing the result obtained by short-term liabilities. This is due to the fact that, of the total assets of a company, inventories are usually the least liquid line, in addition to that they can produce losses more easily. Therefore, this measure of ability to cover short-term debt without having to resort to selling inventories is important.
Acid Test = (Current Assets - Inventory) / Short Term Liabilities
It is sometimes defined as (cash + marketable securities + accounts receivable) / short-term liabilities.
How solvency is measured
Different financial ratios are used to measure the solvency of an economic entity, Rubio (p.18) proposes the following:
- Total solvency Firmness Financial independence
Total solvency
Solvency Total Total = Active real net / total Deudos
Total real net assets are understood to be those resulting from subtracting accumulated depreciation, provisions and depreciable expenses from their full amount. This ratio must be greater than 1, because if it is lower, it would indicate that the company is in bankruptcy. Consequently, the higher this ratio, the greater the guarantee that the company offers to its creditors. It is less significant than liquidity and has the drawback of involving fixed assets with their corresponding valuation and amortization problems.
Firmness
Regarding the medium debts corresponding to the following ratio: and long term, it is interesting to establish the relationship
Firmness = Fixed Real Net Assets / Fixed Liabilities
Real fixed net assets include tangible, intangible and financial assets, estimated at their present value according to the balance sheet. Fixed liabilities include medium and long-term debts. This ratio reports on the financing of fixed assets. A high index expresses that the fixed assets are financed mainly by own capital.
Financial Independence
The relationship between equity and foreign capital determines the degree of financial independence and is found in accordance with the following ratio:
Financial independence = Net equity / Total debts
It is evident that the higher this ratio, the more assured will be the financial stability of the company. It can vary from 0.08 for banks to 0.6 for large industry. It constitutes, at the same time, a solvency index and a performance index, since the external resources have to bear the corresponding financial expense for the concept of interest.
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Here are a couple of video-lessons in which the liquidity and solvency ratios are presented.
Bibliography
- Acosta Altamirano, Jaime. Analysis and Interpretation of Financial Information IESCA 1994Miranda, Miguel A. La Enseñanza with drawings of the Analysis and Interpretation of Financial Statements. Editorial Patria. 1978 Mora Enguídanos, Araceli. Dictionary of Accounting, Audit and Management Control, Volume 3, ECOBOOK, 2009Rubio Domínguez, Pedro. Financial analysis manual. EUMED, 2007
