The solvency of a company demonstrates if the company’s ability to pay its long-term debts. Companies that cannot pay their long-term debts are insolvent. Basically, a company that owes more than it is worth is insolvent. If a company does not have enough cash on hand or from cash flows to meet its long-term obligations, it will likely default on its long-term debts without some outside assistance. If no assistance is provided, the company will have to file for bankruptcy.
The solvency ratio can be used to determine how likely a company is to pay its debts. The ratio = [(net after-tax profit) + depreciation] / (short & long-term liabilities). The ratio is expressed as a percentage. The solvency ratio should only be compared to companies within the same industry.
