What is solvency?
Solvency refers to the ability of a company to pay off its long-term and other financial obligations on time. In this respect, solvency is also referred to as long-term solvency.
Furthermore, a company is considered solvent when it has a net worth, meaning its total assets exceed its total liabilities.
The Companies and Intellectual Property Commission (CIPC) in South Africa defines solvency as: ‘Solvency relates to the assets of the company, fairly valued, being equal or exceeding the liabilities of the company.’
The difference between solvency and liquidity
Solvency and liquidity are both methods to measure a company’s financial health. However, there is a difference between the two terms.
- The term solvency is used to indicate that a company is able to cover its long-term obligations and that it has the capability to continue operations as a ‘going concern.’
The going concern concept also referred to as the continuing concern concept, is an accounting principle, indicating that a company will continue its operating activities for an indefinite period of time, assuming that it will not close down for the foreseeable future.
- Contrarily, liquidity[1], also called short-term insolvency, refers to the ability of a company to meet its short-term debt obligations, implying that the company’s current liabilities can be paid with the available current assets.
In addition, liquidity also indicates how easily and quickly a company can convert its current assets into cash.
The CIPC describes liquidity of a company as follows: ‘Liquidity relates to the company being able to pay its debt as they become due in the ordinary course of business for a period of 12 months.’
Insolvency – the opposite of solvency
Broadly speaking, there are two reasons why a company’s financial status changes from solvency to insolvency.
- A company is unable to pay its debts when they are due, mainly because of cash-flow and liquidity problems, even though its assets exceed its liabilities. This scenario is called commercial insolvency.
- The other scenario, referred to as factual insolvency, occurs when the company’s liabilities exceed its assets.
The former is considered by most analysts as the more appropriate test for insolvency because companies are often factually solvent, but not able to honour their debt obligations due to a state of illiquidity.
The South African Companies Act regarding company solvency
The South African Companies Act (Act 71 of 2008), hereafter referred to as the Act, covers company solvency in the sections that refer to a ‘solvency and liquidity test.’[2] Some of the sections are discussed below:
Section 4 (Solvency and liquidity test)
According to section 4 (1), ‘a company satisfies the solvency and liquidity test, at a particular time if, considering all reasonably foreseeable financial circumstances of the company at that time’:
‘the assets of the company, as fairly valued, equal or exceed the liabilities of the company, as fairly valued,’ and
‘it appears that the company will be able to pay its debts as they become due in the ordinary course of business for a period of:
- 12 months after the date on which the test is considered,’ or
- In the case of distribution (as defined by the Act), in which money or other property (other than the company’s own shares) of the company is involved, ’12 months following that distribution.’
In addition to the requirements mentioned in section 4 (1), section 4 (2) states the following requirements:
‘Any financial information to be considered concerning the company must be based on:
- accounting records that satisfy the requirements concerning accounting records in section 28 of the Act, and
- ‘financial statements that satisfy the requirements about financial statements as explained in section 29 of the Act.
Subject to paragraph (c) of section 4 (2), ‘the board or any other person applying the solvency and liquidity test to a company:
- must consider a fair valuation of the company’s assets and liabilities, including any reasonably foreseeable contingent assets and liabilities, irrespective of whether or not arising as a result of the proposed distribution, otherwise, and
- may consider any other valuation of the company assets and liabilities that is reasonable in the circumstances.’
Paragraph (c) of section 4 (2) determines that ‘unless the Memorandum of Incorporation of the company provides otherwise when applying the test in respect of a distribution’ as defined by the Act, ‘a person is not to include as a liability any amount that would be required, if the company were to be liquidated at the time of the distribution, to satisfy the preferential rights upon liquidation of shareholders whose preferential rights upon sequestration are superior to the preferential rights upon liquidation of those receiving the distribution.’
Section 44 (Financial assistance for subscription of securities)
Section 44 (3) (b) regulates that, ‘despite any provision of a company’s Memorandum of Incorporation to the contrary,’ the board of directors is not allowed to authorise any form of financial assistance, such as a loan, guarantee, or the provision of security unless the board is satisfied that:
- ‘immediately after providing the financial assistance, the company would satisfy the solvency and liquidity test.’
Section 45 (Loans or other financial assistance to directors)
Likewise, section 45 3 (b) forbids the board of a company to authorise financial assistance to directors, unless the board is convinced that immediately after granting the financial assistance, the company would still pass the solvency and liquidity test.
Section 46 (Distributions must be authorised by the board)
According to section 46), a company is not allowed to make any ‘proposed distribution’ (such as a dividend or a payment in lieu of a capitalisation share) unless:
- ‘it reasonably appears that the company will satisfy the solvency and liquidity test immediately after completing the proposed distribution,’ (section 46 (1) (b)), and
- ‘the board of the company, by resolution, has acknowledged that it has applied the solvency and liquidity test’ as described in section 4 of the Act, ‘and reasonably concluded that the company will satisfy the solvency and liquidity test immediately after completing the proposed distribution.’
Section 113 (Proposals for amalgamation or merger)
Concerning amalgamations or mergers of companies, section 113 (1) states that ‘two or more profit companies, including holding and subsidiary companies, may amalgamate or merge if, upon implementation of the amalgamation or merger, each amalgamated or merged company will satisfy the solvency and liquidity test.’
Gauging the solvency of a company
Solvency is an important measure to gauge a company’s financial health since it is an indication of a company’s ability to continue daily operations in the future.
There are numerous ratios to assess the insolvency of a company, as well as financial data available on the financial statements.
Financial data reported on a company’s financial statements
Balance sheet
A summary of all the assets and liabilities of a company is reported on the balance sheet. A company is considered solvent if the realisable value of its assets is more than its liabilities.
Negative shareholders’ equity is an indication of insolvency, implying that a company’s liabilities exceed its assets. Hence, the company has no book value.
A negative equity balance means that a company has incurred losses of such proportions that they totally neutralise the combined total of any retained earnings from previous financial years and investments from shareholders.
Statement of cash flows
The statement of cash flows is useful to gauge company solvency in the sense that it provides the following information:
- The company’s ability to pay off its short-term obligations on time.
- The number of liabilities the company carries, indicating the amount of debt outstanding.
- The company’s history of debt payments, showing whether debt payments are executed regularly to reduce the debt obligations.
Solvency ratios
Solvency ratios, also called coverage ratios or leverage ratios, are calculated to determine whether a company is financially sound and healthy to meet its long-term debt obligations.
Accounting encompasses several different solvency ratios that are useful to gauge the solvency of a company, inter alia, the following:
Solvency ratio
The solvency ratio is a financial metric of crucial importance that enables managers, accountants, and investors to measure a company’s ability to meet its long-term financial obligations.
The formula to calculate the solvency ratio is:
Solvency ratio = (Net income + Non-cash expenses)/Total liabilities
Where:
- Net income = net income (also referred to as net profit or net earnings) after tax.
- Non-cash expenses = depreciation and amortisation.
- Total liabilities = short-term liabilities + long-term liabilities.
A high solvency ratio is an indication that a company is able to stay solvent and financially secure in the long term.
Debt-to-equity (D/E) ratio
The debt-to-equity ratio compares a company’s total debt to its shareholders’ equity, expressing total debt as a percentage of owners’ equity. It is also called the liabilities-to-equity ratio.
The formula for the calculation of the D/E ratio is:
D/E ratio = Total debt/Shareholders’ equity
Debt ratio
The debt ratio, also known as the debt to asset ratio or the total debt to total assets ratio, measures the extent of a company’s leverage, indicating what percentage of a business’s assets are financed through debt, provided by creditors and lenders.
Put differently, it shows how many assets a company needs to sell in order to cover all its debt obligations.
The formula to calculate the debt ratio is:
Debt ratio = Total liabilities/Total assets
Where:
- Total liabilities are also referred to as total debt obligations.
Debt-to-capital (D/C) ratio
The debt-to-capital ratio measures a company’s financial leverage by comparing its total debt obligations to its total capital.
Express differently, the DC ratio determines the proportion of debt that a company utilises to fund its ongoing operations in comparison with capital available.
The DC ratio is calculated as follows:
Debt-to-capital ratio = Total debt/Total capital
Where:
- Total debt = Short-term and long-term debt.
- Total capital = Total debt + Shareholders’ equity.
For instance, if company Perseverance’s DC ratios are 0.40, it implies that 40% of its capital is acquired from debt. A lower DC ratio is preferable because it means that the company is able to pay for capital without depending so much on debt.
Interest coverage ratio
The interest coverage ratio measures how many times a company’s profits can be used to make interest payments on its debt.
The formula for the interest coverage ratio is:
Interest coverage ratio = EBIT/Interest payments
Where:
- EBIT = earnings before interest and taxes. (Earnings is used interchangeably with profit.)
Assets-to-equity ratio
The assets-to-equity ratio measures a company’s total assets in relation to its shareholders’ equity. In other words, it indicates how much of a company’s assets has been funded by its shareholders.
Inversely, the ratio shows the proportion of assets that have been funded with debt.
The assets-to-equity ratio is calculated as follows:
Assets-to-equity ratio = Total assets/Total equity
For example: Company Nearly There has R1 000 000 of assets and R200 000 of shareholders’ equity. This means that 20% of the company’s assets have been funded with equity, and a considerable 80% with debt, which makes the company highly leveraged.
Debt-to-EBITDA ratio
The debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortisation) ratio measure the number of earnings (income) generated and available to cover debt obligations prior to the deduction of interest, tax, depreciation, and amortisation expenses.
The formula to calculate the debt-to-EBITDA ratio is:
Debt-to-EBITDA ratio = Debt/EBITDA
Where:
Debt = Long-term and short-term debt obligations.
A high ratio could be a sign that a company has too many debt obligations.
What is the difference between solvency ratios and liquidity ratios?
Both types of ratios are used by analysts, investors, and accountants to determine a company’s financial health. However, both have different objectives.
As mentioned, solvency ratios are interested in the financial health of a company over the long term, determining whether a company is able to cover its long-term debt obligations.
Conversely, liquidity ratios look at a company’s ability to pay off its short-term liabilities due in 12 months or less, and the ability to quickly convert its liquid assets into cash.
[1] See the article, ‘Liquidity in Accounting Explained for Dummies,’ for more information about liquidity.
[2] All the accentuations in citations from the Companies Act are by the article writer.
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