Solvency is an important financial key figure that provides insight into the health of a company. It shows to what extent a company is able to meet its financial obligations in the long term. In this blog, we explain exactly what solvency is, why it is important and how you can easily calculate it.
What is solvency?
Solvency shows the ratio of a company’s equity to total assets (equity + debt). It thus shows the extent to which a company is financially independent. The higher the solvency, the more resilient a company is to financial setbacks.
A company with high solvency has a lot of equity compared to debt (such as loans or debts with suppliers). This is often seen by investors, banks and other stakeholders as a sign of financial stability.
Why is solvency important?
Solvency is important for several parties:
- Entrepreneurs gain insight into how “healthy” their business is.
- Investors use it to assess the risk of an investment.
- Financiers (such as banks) look at solvency when assessing loan applications.
- Suppliers use it to estimate whether a company can pay its bills.
Low solvency means a company is heavily dependent on external financing. This makes it more vulnerable, especially in economic downturns.
How do you calculate solvency?
The formula for solvency is simple:
Solvency (%) = (Own funds/total assets) × 100
Suppose a company has:
- Equity: € 200,000
- Loan capital: €300,000
- Total assets = €200,000 + €300,000 = €500,000
Solvency is then:
(200.000 / 500.000) × 100 = 40%
In this case, the company finances 40% of its assets with its own funds. This is often considered reasonably healthy. Many banks use a minimum solvency of 25% to 30% as a guideline.
What is “good” solvency?
What is considered good solvency varies by sector. In capital-intensive sectors, such as construction or industry, higher requirements are common than in, say, the service sector. Nevertheless, generally speaking:
- < 25%: vulnerable/risky
- 25% – 40%: average / acceptable
- > 40%: strong / financially sound
Higher solvency gives room for growth, investment or to bridge a financially difficult period.
Improve solvency? Here’s what you can do
If your solvency is too low, there are several ways to improve it:
- Increase equity, e.g. by leaving profits in the company or attracting external investors.
- Reduce debt, by paying off debt.
- Control costs so that your profits go up and so does your equity.
- Sell assets, allowing you to pay off debts or increase your cash.
In conclusion
Solvency is a powerful indicator of a company’s financial stability. It is not a figure you look at every day, but certainly one to keep an eye on regularly-for yourself, your accountant, and your financiers. By making timely adjustments, you can ensure a healthy financial foundation for the future.
