Solvency - How important is it for investor?
While dealing with or while investing in any company, it is very important to analyse the solvency of that company. By solvency, we mean how capable is the company is for meeting its long term commitments. Solvency also indicates whether the company is capable of expanding its area of operation in the long term. So solvency is an important parameter that is considered by an investor when he analyses whether he should invest in that company or not.
What is the best value for Solvency?
There is an optimum level of every parameter. If the solvency of a company is very high, it will indicate that the company is not able to sweat its assets properly, the company is making its assets lie idle and not able to generate sufficient returns out of them. The optimum level of solvency varies from industry to industry and so it is not enough to infer on the viability of a company based on its solvency alone.
Solvency is not Liquidity
One must also not confuse solvency with liquidity as solvency is the ability to meet long term commitments while liquidity refers to the ability of a company to meet its short term liabilities.
How to Calculate Solvency Ratio?
Solvency Ratio = (Net income + Depreciation)/(Short term liabilities + Long term liabilities)
Important
To determine solvency, it is more effective if we consider the cash flow to the company rather than going for the income of the company as only fluid and regular cash flow will ensure that the company is able to meet its obligation in the long term.
