What is Solvency in Accounting?
Solvency is the ability of a company to meet its financial obligations as they fall due. This is a critical aspect of working capital management and directly affects a company's survival and growth opportunities.
What is Solvency?
Solvency, also called liquidity , refers to how easily a company can convert its assets into cash to meet short-term obligations. Good solvency ensures:
- Continuous operation without interruption in deliveries or services
- Creditworthiness with suppliers and financial institutions
- Growth opportunities through investments and expansion
- Competitive advantage by being able to exploit market opportunities quickly
- Financial stability that protects against economic shocks
The Difference Between Solvency and Solvency
It is important to distinguish between solvency and solvency :
| Aspect | Solvency | Solidity |
|---|---|---|
| Time perspective | Short-term (0-12 months) | Long-term (several years) |
| Focus | Liquidity and cash flow | Equity ratio and debt ratio |
| Measurement | Liquidity ratio, cash balance | Equity ratio, debt ratio |
| Risk | Payment problems, bankruptcy | Financial instability, losses |
Liquidity Analysis and Key Figures
Liquidity ratios
Liquidity ratios are the most commonly used measures of solvency:
1. Liquidity ratio 1 (Current liquidity)
Likviditetsgrad 1 = Omløpsmidler ÷ Kortsiktig gjeld
Interpretation:
- Above 2.0: Very good ability to pay
- 1.5-2.0: Good solvency
- 1.0-1.5: Acceptable solvency
- Below 1.0: Weak solvency
2. Liquidity level 2 (Quick liquidity)
Likviditetsgrad 2 = (Omløpsmidler - Varelager) ÷ Kortsiktig gjeld
This rate excludes inventory that may be difficult to convert into cash quickly.
3. Cash ratio (Immediate liquidity)
Kontantgrad = (Kontanter + Kortsiktige investeringer) ÷ Kortsiktig gjeld
Practical Example: Liquidity analysis
Let's analyze the solvency of Example AS :
| Balance sheet item | Amount (NOK) |
|---|---|
| Current assets: | |
| Cash and bank deposits | 500,000 |
| Accounts receivable | 1,200,000 |
| Inventory | 800,000 |
| Total current assets | 2,500,000 |
| Short-term debt | 1,500,000 |
Calculations:
- Liquidity ratio 1: 2,500,000 ÷ 1,500,000 = 1.67
- Liquidity ratio 2: (2,500,000 - 800,000) ÷ 1,500,000 = 1.13
- Cash rate: 500,000 ÷ 1,500,000 = 0.33
Analysis: The company has acceptable solvency, but is dependent on converting accounts receivable and inventory to cash.
Cash flow analysis
The Importance of Cash Flow
Cash flow is the actual movement of cash in and out of a business. Even profitable businesses can have payment problems if their cash flow is negative.
Types of Cash Flow
| Type | Description | Impact on ability to pay |
|---|---|---|
| Operational | From daily operations | Most important for short-term solvency |
| Investment | From purchase/sale of fixed assets | Affects long-term capacity |
| Financing | From loans and equity | Supports solvency when needed |
Cash flow forecast
A cash flow forecast is essential for predicting solvency:
Kontantbeholdning (slutt) = Kontantbeholdning (start) +
Kontantinngang - Kontantutgang
Factors Affecting Solvency
Internal Factors
- Credit period to customers: Longer credit period reduces cash inflow
- Inventory rotation: Slow inventory turnover ties up capital
- Supplier credit: Longer payment terms improve liquidity
- Seasonal variations: Affects both income and costs
- Investment decisions: Large investments can affect liquidity
External Factors
- Market conditions: Affect sales and payments
- Interest rate level: Higher interest rates increase financing costs
- Business cycles: Recessions can delay customer payments
- Regulatory changes: New requirements may affect cash flow
- Currency fluctuations: For businesses with foreign trade
Strategies to Improve Solvency
Short-term Measures
Increase Cash Inflow
- Faster invoicing: Automate the invoicing process
- Shorter credit period: Reduce payment deadlines to customers
- Cash Discounts: Offer a discount for prompt payment
- Efficient collection: Follow up on overdue invoices with payment reminders
- Factoring: Selling accounts receivable to finance companies
Reduce Cash Outflow
- Negotiate supplier credit: Get longer payment terms
- Optimize inventory: Reduce inventory tie-up
- Postpone investments: Prioritize critical acquisitions
- Cost reductions: Cutting unnecessary expenses
Long-Term Strategies
Structural Improvements
- Diversify customer base: Reduce dependence on large customers
- Improve product mix: Focus on profitable products
- Invest in technology: Automate processes
- Strengthening market position: Building competitive advantage
Financial Planning
- Establishing credit lines: Securing access to financing
- Building cash reserves: Maintaining liquidity buffer
- Monitoring key figures: Implementing dashboards and reports
- Scenario planning: Preparing for different market situations
- Budgeting : Systematic planning of cash flows and liquidity needs
- Alternative financing methods: Consider crowdfunding or crowdlending for quick access to capital without traditional bank loans
Risk Management and Solvency
Identification of Liquidity Risk
Liquidity risk arises when a company is unable to meet its payment obligations. Early warning signs include:
- Falling liquidity levels over several periods
- Increasing accounts payable and delayed payments
- Reduced cash balance without planned outflow
- Difficulty in obtaining credit from banks or suppliers
- Increased interest costs due to higher risk premium
Contingency plans
A good liquidity position includes:
| Emergency level | Measures | Time horizon |
|---|---|---|
| Green | Normal operation, monitoring | Continually |
| Yellow | Reduced investments, increased focus | 1-3 months |
| Red | Emergency measures, external financing | Immediately |
Solvency in Different Industries
Industry-Specific Challenges
Retail
- Seasonal variations: Large fluctuations in cash flow
- Inventory risk: A lot of capital tied up in inventory
- Short credit period: Customers often pay in cash or by card
Construction
- Long projects: Cash outflow before revenue
- Advance payments: Depending on customer advance
- Weather risk: Can affect progress and costs
Service provision
- Low capital tied up: Less need for working capital
- Customer concentration risk: Dependence on large customers
- Competence risk: Loss of key personnel
Benchmarking
Comparison with industry averages is important for assessing solvency:
| Industry | Typical liquidity ratio 1 | Typical cash rate |
|---|---|---|
| Retail | 1.2-1.8 | 0.1-0.3 |
| Industry | 1.5-2.2 | 0.2-0.4 |
| Services | 1.8-2.5 | 0.3-0.6 |
| Construction/facilities | 1.1-1.6 | 0.1-0.2 |
Digital Tools for Solvency Analysis
Modern Solutions
Accounting systems
- Automatic reporting of liquidity key figures
- Integrated dashboards for real-time monitoring
- Forecasting functionality based on historical data
Specialized Tools
- Cash flow planning: Detailed forecasts
- Credit monitoring: Automatic follow-up of accounts receivable
- Bank integration: Real-time account balances and transactions
Implementation of Surveillance Systems
Effective monitoring of solvency should include:
- Daily reporting of cash balances
- Weekly forecasts for the next 13 weeks
- Monthly analyses of liquidity ratios
- Quarterly benchmarking against the industry
Legal Aspects of Payment Problems
Consequences of Poor Creditworthiness
When the ability to pay fails, it can have serious legal consequences:
Bankruptcy risk
- Insolvency: Unable to pay debts due
- Illiquidity: Lack of liquid funds to cover obligations
- Bankruptcy petition: Can be filed by creditors or the company itself
Responsibility for Management
- Duty of care: Management must act responsibly
- Duty to inform: Notify the board of payment problems
- Liability: In the event of irresponsible continuation
Preventive Measures
To avoid legal problems:
- Regular monitoring of solvency
- Early notification to the board of any problems
- Professional advice on financial challenges
- Documentation of decisions and actions
Conclusion
Solvency is fundamental to the survival and growth of any business. Good liquidity management requires:
- Continuous monitoring of key figures and cash flow
- Proactive planning with forecasts and scenario analyses
- Balanced approach between growth and financial stability
- Contingency plans to handle challenges
By understanding and actively managing their ability to pay, companies can ensure stable operations, seize growth opportunities, and build long-term competitive advantage. This requires both analytical skills, strategic thinking, and operational discipline.
Remember that solvency is not just about survival - it is about creating a foundation for sustainable growth and value creation. A company with strong solvency has the freedom to invest, innovate and exploit market opportunities as they arise.