Solvency

Solvency ⇒  is the ability of the company to pay its long-term obligations as they come due. In contrast to liquidity, which is the ability to pay short-term obligations by liquidating current assets, solvency is the ability to pay long-term obligations from earnings. A firm is solvent if its assets are greater than the sum of its debt obligations.

The composition of a company’s capital structure is an important part of solvency analysis. In addition to capital structure, solvency depends upon successful, profitable operations, because profits are the source of the cash to make interest and principal payments. Therefore, solvency analysis also involves analysis of earnings and the ability of those earnings to cover necessary company expenditures, including the required debt service.

A company with more equity than debt is more stable and solvent than a company with more debt than equity. A company can invest equity financing in long-term assets and expose them to business risk without any risk that the financing will be recalled. Debt financing, however, may be recalled if the firm defaults on the debt. A default on a debt is not only the failure to make scheduled payments. Default can also occur without the company’s missing any interest or principal payments. If the borrowing agreement includes covenants such as a required current ratio or a required debt-to-equity ratio that must be maintained, failure to adhere to the debt covenants can result in default and cause the entire principal plus accrued interest to become due and payable.

If a company has a lot of long-term debt relative to its assets, it has lower solvency than a company with less long-term debt. A company with higher long-term debt assumes more risk of default and insolvency than a company with lower long-term debt because with higher long-term debt, more of the assets of the company will be required to meet the scheduled interest and principal payments. Because these payments must be made whether the company has positive or negative future earnings, a high level of debt financing increases the risk of default and insolvency.

A company can change its capital structure in several ways. If the company issues stock and uses the proceeds to pay off long-term debt, it decreases its debt while increasing its equity, thus increasing its solvency. If outstanding convertible bonds are converted to equity, solvency is also increased. On the other hand, if a company borrows in order to raise funds that are then used to purchase treasury stock , it increases its debt and decreases its equity, thus decreasing its solvency.