Solvency is the ratio between assets or equity and liabilities or debt. The outcome of a solvency calculation shows the extent to which a business relies on external parties and its ability to meet long-term financial obligations.
Why is solvency important?
Strong solvency is essential for sustainable growth. When a business has sufficient equity, the risk for banks and other financiers is reduced. This makes it easier to obtain a business loan for investment purposes. Healthy solvency also gives you greater control over your organisation’s financial position.
How do I calculate my solvency?
You can calculate a business’s solvency with the following formula: (equity / total assets) x 100% = solvency ratio
Example of solvency calculation:
(£ 200,000 / £ 400,000) x 100% = 50%
This calculation shows a solvency ratio of 50%. In other words, half of the balance sheet consists of equity. Lenders may, however, make adjustments to this calculation, which can lower the assessed solvency. Credit providers generally consider a solvency ratio between 25% and 40% to be acceptable.
How do I improve my solvency?
A business can improve solvency in several ways, such as reducing debts or increasing equity. Effective credit management plays an important role here: the faster outstanding invoices are paid, the quicker debts can be reduced. Equity can also be strengthened by increasing profits and cutting costs.
Lowering working capital can have a positive impact as well. This applies not only to credit management, which ensures outstanding invoices are settled more quickly, but also to maintaining smaller stock levels. A reduced inventory lowers total assets, which in turn improves solvency, provided equity remains at least the same.
