A solvency ratio is a calculation to measure the financial health of your business. It is an indication of your ability to meet your payment obligations long-term. What does solvency mean to your business? And how does a financier or supplier assess your solvency? Learn how to calculate your solvency ratio and how to improve your financial position.
What is solvency and why is it important?
A solvency ratio shows the relationship between equity and total assets. This simple calculation determines if your business can meet its debts in the long term. A higher solvency ratio can be seen as a financial buffer if your business is ever in trouble.
Financial resilience
A high solvency ratio means your business is in a strong financial position. You are less dependent on external lenders because your investments are mainly covered by your business activities. The sale of your assets will be enough to pay creditors if anything goes wrong.
A high solvency ratio gives business partners and suppliers more security. They see that you can pay them. It is also important for financing. A higher solvency ratio means a financier carries less risk. Your business may even receive a lower interest rate.
How do you calculate your solvency ratio?
Use this formula to calculate the solvency ratio of your business:
- (Equity / Total assets) x 100% = Solvency ratio
Your equity is the value of assets in your business minus liabilities.
Your total assets include both equity and loan capital (the money your business has borrowed).
Fixed assets are present in your company for more than a year, such as equipment or property. Current assets are present in your company for less than a year, such as inventory or money owed by customers.
Liabilities are existing debts that finance assets. These include contributed equity (own money and funds) and debt (money from third parties). Long-term liabilities have a term of more than one year. Short-term assets have a term of less than one year.
Please note: equity also includes any reserves and provisions.
Balance sheet and profit & loss
The balance sheet in your annual accounts shows your equity and total assets. Think of this as a snapshot of the assets, liabilities and equity in your business at a single moment. Of course, your ongoing activities mean your accounts look different every day. One day you receive money from a debtor, buy goods, or pay taxes. You can see this on your interim balance sheet and your profit and loss statement.
Look at your accounts once a month to calculate your solvency ratio. Track the changes over time to gain more insight into the financial fitness of your business.
An example solvency ratio calculation
If your equity is €50,000 and your total assets are worth €150,000, your solvency ratio is:
- (50,000 / 150,000) x 100% = 33%
What is a good solvency percentage?
Financiers consider a good solvency percentage to be between 25% and 40%. Every company and industry has their own characteristics that influence the financial outlook. Having a lot of cash usually has a positive effect. A large inventory that is difficult to sell has a negative effect. Financiers are attracted to a high solvency ratio as the risk of being unable to repay a loan is smaller.
The standards for solvency ratio vary by sector, by type of company and by financiers. As well as solvency, other calculations and ratios can reflect the financial situation of your business. For example, liquidity and profitability. Liquidity shows if you can meet your short-term payment obligations. Profitability shows how profitable your business is in relation to working capital. The Netherlands Chamber of CommerceKVK Book of Financehas more information on various calculations and ratios and how financiers use them.
Solvency and borrowing requirements
TheCBS FinancingMonitor(in Dutch) tracks the relationship between SMEs and financing. In 2020, the businesses that did not need financing had a high solvency ratio (higher than 50%). They had a lot of equity compared to the total balance. This meant they could finance from their own funds. The solvency ratio of companies that needed financing was lower (higher than 25%). They were more likely to need external financiers.
Improve your solvency
Depending on your situation there are various ways to improve your solvency. A financial advisor can help you find the best solution for your business. Consider these options:
- Ask your customers to pay sooner. Fewer outstanding invoices mean more money in your account. You will borrow less for working capital. As the loan capital on your balance sheet decreases, your solvency ratio increases.
- Considerfactoring. Pre-financing invoices reduce the number of days you wait for invoices to be paid and the number of outstanding debtors.
- Optimise your inventory. Money is locked up in your goods until they are sold. The smaller your inventory, the lower your total assets. Lower total assets with the same equity mean a higher solvency ratio.
- Ask your supplier for a discount if you pay quickly. This gets you a higher return on surplus cash.
- Distribute less profit (dividends). Keep profit in your company and add it to the general reserves. This increases equity.
- Increase your profits. Extra profit means more equity. Increase your income or cut costs for higher profitability. Be critical of your purchasing and sales prices.
- Consider sale and leaseback. Some assets, such as equipment, can be sold and leased back to you. If you make a book profit, your equity increases. You can also use this money to pay off debts.
- Invest your own money in the business. In asole proprietorship,general partnership (vof)orlimited partnership (cv), you can invest private money in your business. This increases your equity. In aprivate limited company (bv), you can buy shares in your business or provide a loan. You can subordinate the loan to a creditor, such as a bank. A financier sees this as 'liable bank capital'. If debts have to be settled, any money owed to the bank is paid first.
