Many companies focus primarily on short-term profit, which is without a doubt a vital matter. Still, in these companies’ attempt to increase profits, they turn to a form of financing, which is debt, which puts the company’s financial solvency at risk. To understand solvency, we first need to understand assets and liabilities.
There are many ways to do this, but one of the main ways a company’s solvency can be determined is by looking at the Solvency Ratio. The solvency ratio measures whether the company has sufficient cash flow to pay off its debt and other financial obligations. This ratio is essential not only for the company when deciding about its economic future but also for lenders. The decision is whether to lend the company more money.
Solvency Ratio =
(Net profit after tax + depreciation) ÷ Total liabilities (current and non-current)
The firm must remain solvent as this shows the firm’s ability to stay in business. Suppose the company owes more than it owns in assets and stops fulfilling its financial obligations. In that case, it will become insolvent and most likely enter into insolvency proceedings – which means taking legal measures to convert the company’s assets into cash to pay off the company’s debts.
By tracking a company’s solvency ratio, you can not only help reduce the risk of the company going bankrupt, but it can also give a larger picture of whether the company needs more debt or not. Not only does the solvency ratio help the company make critical financial decisions to keep the company profitable, but it also gives the lenders an idea of whether or not the company will be able to pay off its debts. When lenders scroll through a company’s financial statements, they will usually use the solvency ratio as the basis for creditworthiness. Firms with lower solvency ratios are considered to have higher risks for banks and lenders and vice versa.
To boost the company’s solvency ratio, the first step is to generate more profits. As well as routinely review the financial statements and calculate the solvency ratio. It is essential to keep track of this number so that the company does not resort to incurring any debts that may harm it in the long term.