## Solvency | Definition | Calculation (with Example)

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going to learn an important topic that’s called solvency. One of the most

important thing that every company is looking for so let’s understand see

solvency is the ability of the firm to continue that service this is a very

important word to continue its operations for a longer period of time

so the whole concept is to continue the operations for a deep perpetual period

of time you can say so what exactly is the solvency well. Solvency is basically

the ability of the firm to continuous the operation for a longer period of

time so in simple terms solvency basically ensures whether a firm is

it’s not enough to pay off its long-term debt so the basic difference between the liquidity and the solvency is all about

the firm’s ability to pay off its short-term debt so in the case of

liquidity or long-term debt in case of the solvency so here instead of taking

the company’s example we’ll try to understand the solvency from an

individual perspective for taking individual perspective will ease

remember one thing what we are doing is we are trying to learn the individual perspective over here the individual

perspective is going to ease of the process as an in an investor who is

investing in to come his individual individually would be able to understand

when to go for big investment and when to retreat. So let’s take a solvency

example let’s say there is a guy called mr. Gordon

who wants to invest in a company his friend basically told him that it’s a

very good idea to invest into a particular company since the company is

doing quite well but mr. Gordon he isn’t sure whether he has enough money to get

into something so he goes to one of his friends who invests into the

company the friend tells him to look at the solvency of the individual account

so what exactly comes up I’m going to bifurcate over here as

assets which is the first thing which includes your cash, house, car, and any

other assets cash let’s say if this is 50,000, $200000, $15000 and $10000. So this are the assets this is

what he is going to look forward to then there is liability any let’s say

educational loan for his let’s say for his first child

that he must have taken let’s say $30,000 then the mortgage on the house if any he has taken let’s say $100000 credit card debt if any

which is let’s say $20000. So mr. Gordon now we know he decides to

find out how much total assets he owns and how much total liability he has to

pay off so the total asset over here cash, house, car, other assets

which will give us about total assets our total asset is going to be all is

equal to which is $275000 and then we have the liabilities so our total

liability is going to be $150,000

right this is our total. So now mr. Gordon wants to know his net worth

so his investor friend mentions after that after liquidating his assets

and liability if mr. Gordon sees that he is still left with a positive net

worth he should go ahead and invest in that particular company and his another

friend suggested so if mr. Gordon finds that his net worth that is your net

worth if he is net worth is negative then it’s better to first to pay off all

its additional debt so mr. Gordon deduct his total liability from the total asset

and comes up with the following so the net worth goes something like this

is equal to your bracket the total assets less the total liability so your

total assets is equal to $275,000 your total liability $150,000

which gives you your $125,000. as the net worth so from the

above calculation mr. Gordon gets clear idea about what he should invest in a

company right now or not since his net worth is positive and he would have a

healthy amount in his pocket even after paying off all his all he owes he

decides to go ahead with his investment. Now let’s understand the solvency of a

company. now if you’re running a business you

want to invest into a project or buy a chunk of shares you if you want to in a

new startup so first you need to find out how much the net worth

how much the net worth of the of your company has if your company is

liquidated immediately can your company be able to survive for some time at

least I would say sometime at least so for example, the approach would be a bit

different because in the case of the companies you need to think you need to

think through of fixed expenses okay the fixed expenses your variable expenses

every month and your production costs, serving costs and so on and so forth so

as a company owner you need to make sure that you have at least

six months to one year of working capital ready before investing in any

new project so plus based on this you require

additionally the company can use debt to equity ratio

the de ratio and any interest coverage ratio to find out whether the firm is able to pay its long-term

debt or not. Now the debt to equity ratio would tell the company that whether its

equity if its equity is enough to pay off its debt rate or else the form can

check its income statement and can find out the ebit and the interest charge

for the debt payment and they will get an idea about whether they have

enough earnings before interest in taxes to pay off the interest payment for a

debt however whether to invest in a project or not is completely a different

ballgame altogether so that’s it for this particular topic if you have

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