Solvency is the ability of a company to comply with its obligations and generate funds to meet the commitments sealed with third parties under pre-established conditions.
The term solvency encompasses all types of commitments, both short and long term. It has always been linked to the concept of credit risk, since it represents the probable loss that the modification of the conditions would imply for the company that could change its ability to comply with the contractual agreements established in its operations.
The concept of solvency should not be confused with liquidity. The latter is restricted to the ability of the company to obtain liquid resources through their exploitation, when solvency can be obtained with non-liquid resources, provided that they imply correct support when it comes to settling debts.
Liquidity is one more degree within solvency, which implies that a company with good liquidity is solvent, but the opposite does not happen. A company can be solvent but not produce liquidity.
Another term that is also identified with solvency is profitability. It refers to the economic aspect of the entity, not being valid only the simple generation of resources, since it is also required that these, in the form of benefits, are of an adequate size that cover the remuneration of shareholders or partners, and that they also facilitate self-financing adapted to the needs of the same. In this case, there is the possibility that a company will be profitable but not solvent.
How to measure creditworthiness
There are different financial ratios to measure the solvency of a business, among which are total solvency, firmness and financial independence.
- Total solvency equals Total Real Net Assets / Total Debts.
- Firmness equals Real Fixed Net Assets / Fixed Liabilities.
- Financial independence equals net worth/ total debt.