Solvency
Solvency: an important term in the business and financial field. When you have your own business, it is important to know the solvency percentage. This indicates the long-term expectations of your business. But what exactly is solvency and how can you calculate it? When do you need a solvency statement and where do you request these details? There can be many questions in the field of solvency; the answers will give you a better understanding of the details of your own business. But this is especially interesting information for external parties.
The meaning of solvency
What exactly is solvency? This term indicates whether your company is sufficiently solvent. This means that the solvency percentage of the company can be seen as whether the debts can be repaid when the company goes bankrupt or stops. Solvency therefore mainly concerns long-term obligations. Before investors (the bank or external parties) provide you with a loan, they are interested in these details. The solvency ratio indicates the extent to which a company is dependent on loan capital (the loans and debts that a company has built up). Solvency therefore indicates whether a company can meet its payment obligations in the longer term.
Assets and liabilities
Another umbrella word for the possessions of buildings, goods and thus possessions is assets. Liabilities refer to equity and loan capital. The liabilities therefore form the means with which the assets (possessions) are financed. The table below provides a useful overview of this information.
Assets (possessions) | Liabilities (equity) |
Fixed assets (capital) | Equity (shares, profit) |
Current assets (inventory) | Loan capital (loan, debt) |
When do you need a solvency statement?
You need a solvency statement when you want to apply for a loan or credit from a bank or another investor. You can do this, for example, at the bank where you also have a business account . These external parties need these details so that they can demonstrate what risk they might run. When there is good and healthy solvency, there is a good chance that a loan will be provided. In case of poor solvency, which means that the company in question cannot repay the debts in the event of bankruptcy, the bank or investor can withdraw.
Solvency, liquidity and profitability: the differences
The concept of solvency can be confused with liquidity and profitability. These are both financial terms that indicate a certain ratio in your business. The solvency of a company therefore indicates the relationship between equity and loan capital. What do liquidity and profitability mean? Liquidity stands for the next one: can the company meet costs that must be paid within a short period of time? For example, does your company have enough money in its cashier to pay a certain amount next week? For this you therefore look at liquidity. Profitability indicates how much profit a company makes with respect to the money invested by external parties. This is an interesting ratio for you as well as for investors.
A healthy percentage
Good solvency is therefore important for your company in the long term, but when is there a healthy solvency percentage? In principle, the higher the solvency, the better. Yet there are guidelines for when the percentage is seen as healthy. If the solvency of your company is between 25% and 40% , this is a good percentage. For example, equity is $ 750,000 and total equity is USD 2.5 million. By using the formula dividing equity by total equity x 100, you arrive at a percentage of 30%, so a healthy solvency ratio.
Finding lenders
Why is it so important to have good solvency? There are several reasons why it is attractive for yourself and others to have a good solvency percentage. For example, providers of loan capital are interested in your solvency, because they can determine the risk of their loan on this basis. The lower the solvency of your company, the greater the risk and the greater the chance that these providers will forgo a loan.
The influence of investors
Not only providers of money, but also investors find it interesting when solvency is healthy. The stock market mainly looks at the stability of a company, so that your company becomes more attractive to buy back shares. The more people buy a share in your company, the greater the equity becomes. This also has a positive effect on the solvency of your company. This creates a vicious circle that works in your favor.
Attracting business partners
Your company also becomes attractive to business partners when solvency is good. When you demonstrate that your company has a healthy solvency rate, good liquidity but also integrity, it will be easier for potential future business partners to make a choice. They would like to work with a healthy company that has a lot of potential. Good solvency certainly contributes to this.
Poor solvency: the causes
You may also have poor solvency , which means that your company is unable to pay off debts in the long run. This means that you are not solvent enough for investors and lenders to invest in. What can be the cause of a poor solvency ratio? Everything revolves around the good balance between equity and loan capital. When an agreement is made with a bank or other external party, a solvency ratio is set to which your company must adhere: this is included in the credit agreements. Failure to achieve this ratio can lead to poor solvency.
What are the relationships in the company?
Poor solvency also means that most of the business consists of debt. This means that a company is almost completely dependent on lenders, but is also not completely healthy financially. Suppose your company has a solvency percentage of 10%. This means that the remaining 90% consists of loan capital. This is not attractive for lenders and getting a loan will therefore be difficult. There is also a risk associated with paying off these debts.
Low interest, buying on account and economic downturn
There are more reasons why poor solvency can occur. For example, a low interest rate when attracting loan capital can ultimately lead to poor solvency. Even if you as a company can buy on account from suppliers, this can jeopardize the solvency percentage. In the event of an economic setback, there is also a possibility that this has negative consequences for the solvency of your company; money (equity capital) must be used to absorb these blows.
How can you improve solvency?
It has been stated earlier: the importance of a good balance between equity and loan capital. Poor solvency is often caused by the use of equity capital, for example to absorb an economic setback. It is therefore important to get more equity capital in relation to the loan capital. In this way you can improve the solvency ratio. How can you achieve this? There are two workable solutions for this.
The improvement of working capital
The first way to improve solvency again is by improving working capital. Ensure good credit management, as well as clear debtor and stock management. This ensures that the company has to borrow less money to finance the working capital. This means that less borrowed capital is needed, and as a company you can work towards a healthy solvency ratio again: a good ratio between equity and borrowed capital.
Reducing the profit distribution
Equity will also grow when you will not distribute or withdraw too much of the profits from the business. This means that no or much less dividend is paid out. Dividend means that a portion of the profit of the company is distributed to the investors or shareholders. Thus, when no dividend is paid, it means that all of the company's profits are used to reinvest in the company. In this way you as a company can work on your solvency ratio.
Calculate the solvency of your company
In order to determine what your company's solvency rate is, you need to find out these details. When calculating solvency, equity and loan capital are taken into account. Solvency can be calculated in three different ways: the result of this calculation is called the solvency ratio or the solvency percentage. With this calculation, a balance is drawn up, as it were, between equity and loan capital. It does not matter which formula is used to calculate solvency.
Calculation 1
The first and most commonly used calculation is as follows:
total power
—————————- x 100
debt
Total assets are also referred to as total assets: this refers to all of a company's assets. This includes borrowed and equity capital, as well as fixed assets, current assets and cash and cash equivalents. Fixed assets are capital goods such as a building or machines that last for a long time. Current assets are resources that are temporarily carried along, such as stock of goods or cash. Cash is the money in the bank and in the cashier with which your company can make the payments. Loan capital concerns the total of loans taken out by the company: this concerns both short-term loan capital (short-term debts) and long-term loan capital (long-term debts).
A calculation example on calculation example 1
Below is a table with an example of a calculation according to the above formula.
Assets (possessions): | Cost: | Liabilities (equity) | Cost: |
Fixed assets: | Equity: | ||
Buildings | $ 1,600,000 | Shares | $ 1,200,000 |
Machines | $ 800,000 | Reserves | $ 170,000 |
Means of transport | $ 250,000 | Profit to be distributed | $ 350,000 |
Current assets: | Long loan capital: | ||
Stock goods | $ 85,000 | Loan mortgage | $ 600,000 |
Liquid assets: | Loan privately | $ 325,000 | |
Bank | $ 35,000 | Short-term loans: | |
Kas | $ 16,000 | creditors | $ 35,000 |
Loan bank | $ 100,000 | ||
Current account | $ 10,000 | ||
Total: | $ 2,786,000 | Total: | $ 2,790,000 |
In this case, the solvency is calculated as follows:
2,786,000
——————— x 100 = 260%
1,070,000
Calculation 2
The second formula that can be used to calculate solvency is as follows:
equity
—————————– x 100
debt
So, equity is an amount owned by your company. In the case of a sole proprietorship or a general partnership, this money has been put into the business by the owner himself and is therefore not borrowed from an external party. In a Private Company (BV) or NV the equity capital represents the money belonging to the company, made available by shareholders. The loan capital represents all loans (short and long) applied for by the company.
An example calculation on calculation 2
Below is a table with an example of the calculation according to the above formula. The same details were used as in the first table.
Assets (possessions): | Cost: | Liabilities (equity) | Cost: |
Fixed assets: | Equity: | ||
Buildings | $ 1,600,000 | Shares | $ 1,200,000 |
Machines | $ 800,000 | Reserves | $ 170,000 |
Means of transport | $ 250,000 | Profit to be distributed | $ 350,000 |
Current assets: | Long loan capital: | ||
Stock goods | $ 85,000 | Loan mortgage | $ 600,000 |
Liquid assets: | Loan privately | $ 325,000 | |
Bank | $ 35,000 | Short net worth : | |
Kas | $ 16,000 | creditors | $ 35,000 |
Loan bank | $ 100,000 | ||
Current account | $ 10,000 | ||
Total: | $ 2,786,000 | Total: | $ 2,790,000 |
In this case, the solvency is calculated as follows:
1,720,000
———————- x 100 = 160%
1,070,000
Calculation 3
The third formula for calculating solvency is as follows:
equity
—————————- x 100
total power
In this formula, the equity is therefore divided by the total equity. Equity therefore again includes shares, reserves and the profit to be distributed. Total capital includes everything that falls under liabilities: equity, short-term loan capital and long-term loan capital.
An example calculation on calculation 3
Below is a table with an example of the calculation according to the above formula. The same details were used as in the first table.
Assets (possessions): | Cost: | Liabilities (equity) | Cost: |
Fixed assets: | Equity: | ||
Buildings | $ 1,600,000 | Shares | $ 1,200,000 |
Machines | $ 800,000 | Reserves | $ 170,000 |
Means of transport | $ 250,000 | Profit to be distributed | $ 350,000 |
Current assets: | Long loan capital: | ||
Stock goods | $ 85,000 | Loan mortgage | $ 600,000 |
Liquid assets: | Loan privately | $ 325,000 | |
Bank | $ 35,000 | Short-term loans: | |
Kas | $ 16,000 | creditors | $ 35,000 |
Loan bank | $ 100,000 | ||
Current account | $ 10,000 | ||
Total: | $ 2,786,000 | Total: | $ 2,790,000 |
In this case, the solvency is calculated as follows:
1,720,000
——————— x 100 = 61%
2,790,000
The meaning of the percentage
The solvency percentage can therefore be calculated in three different ways. But what does this percentage mean? This has a different explanation for all three formulas.
- Example 1: a percentage of 260%. This means that the ratio between the loan capital and the total capital is 1 to 2.6. This means that of every $ 2.60 in the company, $ 1 is borrowed.
- Example 2: a percentage of 160%. This means that the equity capital is 1.6 times as large as the loan capital. The outcome with this formula is always 100% lower than the first formula.
- Example 3: a percentage of 61%. This means that the total capital consists of 61% equity, which is 39% debt. If the outcome here would be 100%, this means that a company is not at all at fault.
Gathering the details
If you want to use a loan from a bank or another external investor, they will ask for the solvency ratio. You need your financial details to calculate the solvency ratio. You can figure this out yourself, but you can also ask for help . You can think of an accountant or a bookkeeper who has insight into these details. They can calculate this for you quickly and easily. In addition, there are many other external parties to whom you can outsource this task.
Is there a standard for solvency?
As said before: the higher the outcome of a formula, the more favorable it is. We also know that when a solvency percentage is between 25% and 40%, this is a healthy situation. A percentage of more than 40% is also considered favorable. There are mainly guidelines rather than requirements when it comes to solvency. This means that there are no fixed percentages that a company must or may have at least. A bank or other external investor can set a certain standard. In this way, they make it clear to themselves and borrowers which ratio is approximately used. In this way, they do not place themselves in the risk zone and they can make a decision more easily.
Other reasons for a loan
In addition to solvency, an external party also looks at other aspects of a company. It is therefore also possible that a company with an extremely low solvency is still attractive to invest in. For example, it also looks at the expected turnover of a company, but also the liquidity (payment obligations in the short term) and the profitability (the profit of the company per USD turnover). A certain brand name or the market potential of a company can also be the deciding factor in offering a loan.
Calculate the solvency
In order to calculate your solvency percentage you therefore need your financial details. By using one of the possible formulas you can determine how your company is doing. Lenders can determine whether they want to provide you with a loan based on this information. The higher the solvency ratio, the more favorable this is. Especially when your equity capital is greater than the loan capital, the chance of a loan is very high. However, the lenders also look at other factors of your company: among other things, the market potential, liquidity and profitability.