# What Solvency Is in a Business

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One of the primary objectives of any business is to have enough assets to cover its liabilities. This is known as solvency. Along with liquidity and viability, solvency enables businesses to continue operating.

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.

### Key Takeaways

• Solvency is a measure of a business's financial viability. Your business is solvent when you have more assets than debt.
• You can use the current ratio or the quick ratio to calculate your business's solvency.
• Solvency is a long-term measure of a business while liquidity is a short-term measure that looks at how quickly a business can sell its assets.
• Viability is another long-term measure often confused with solvency which measures a company's long-term profitability.

## 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.

### Note

In order to be solvent and cover liabilities, a business should have a current ratio of 2 to 1, meaning that it has twice as many current assets as current liabilities. This ratio recognizes the fact that selling assets to obtain cash may result in losses, so more assets are needed.

### 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.

### Note

These ratios are important for both business owners and for lenders. If a bank is considering a loan to a business, it will look carefully at these ratios to determine if the business already has too much debt and not enough assets to pay off that debt.

## 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.

### Note

Liquidity relates more to short-term cash flow, while solvency relates more to long-term financial stability.

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.

## How do I determine the solvency of a company?

You can use the current or quick ratios to determine whether or not a company is solvent. Overall, you're looking to see if the company's assets are worth more than its debts.

## What is a good solvency ratio for a company?

The higher the solvency ratio, the better equipped a company is to handle debt. Typically a good benchmark for a current ratio is 2 to 1, while you're looking for your company to have a quick ratio of 1 to 1 or higher.