It’s vital that businesses do everything in their power to remain solvent. Businesses have a range of liabilities, and when they are able to keep on top of them they can stay prosperous and plan more effectively. Assets are incredibly important to businesses, and when they don’t have enough, they may struggle to pay their bills, which can result in disaster. There are various ways to measure whether your business is solvent.
What is a balance sheet?
A balance sheet is directly linked to solvency and shows how assets relate to liabilities and equity or ownership. Each asset that a business owns will have been bought with a debt/liability or the business’ capital, otherwise known as its equity. This explains why solvency is frequently measured as a ratio between assets to liabilities.
How is solvency measured?
There are two different ratios used to measure a business’ solvency. The current ratio is a business’ total assets divided by their total current liabilities. These assets include cash, prepaid expenses and inventories. As some long-term assets can’t be sold quickly enough to cover bills, they are not included in this ratio. Generally, businesses need to aim for a ratio of 2:1. In other words, their current assets need to be worth twice as much as their liabilities.
The quick ratio
With the quick ratio, only cash and accounts receivable are used. These can be used to swiftly cover debts when emergency cash is required. In this case, you would need to aim for a 1:1 ratio, which means the cash and accounts receivable would need to equal the amount of debt that needs to be paid off. Achieving this ratio can be a much tougher challenge, especially for smaller, growing businesses. Lenders will take a close look at these ratios when attempts to raise finance are made.