You may have heard the word “solvency,” but never given much consideration to what it means. While sometimes it is associated with liquidity, it can mean different things.
One idea of solvency has to do specifically with a business’s ability to pay its short-term obligations. In other words, a business has short-term liabilities on its balance sheet that need to be paid within 12 months, and so long as current assets and cash flow meet or exceed the amount of current liabilities over the same period, the company can remain solvent.
Another way insolvency is interpreted is when total liabilities exceed total assets, leaving the company with no net worth or negative net worth. The company may have liquidity to operate, but due to a lack of net worth, it may be more desirable to declare bankruptcy. Insolvency, due to a lack of net worth, can happen instantaneously. Say a company has $100,000 in assets, and $50,000 in liabilities. A company in this situation is relatively okay. Now say that same company has an unfavorable legal ruling, and now they have a $200,000 lawsuit they must pay. Now total liabilities are $250,000. The company actually has a negative net worth of -$150,000. The owner may find it easier to declare bankruptcy than try to satisfy the lawsuit. This single action leads to company insolvency.
If a business can remain solvent and is expected to remain operational for the next 12 months, it is referred to as a “going concern.” If a business has circumstances that call into question the ability of it to remain operational in the next 12 months, it is not a going concern. This comes from an older usage of the word “concern” which meant “business.” If you receive an audit or information that says the business you are financing is not a going concern, you should be very concerned!
If a business fails to remain solvent, then bankruptcy may be inevitable. Bankruptcy is when the justice system intervenes to provide an orderly way to repay creditors or discharge debts. There are different types of bankruptcies for individuals and businesses. Chapter 13 is when an individual tries to restructure their debts in a way where they can better repay them. Chapter 11 allows a similar situation, except it applies mostly to businesses. Chapter 12 is similar to 11 and 13, except it applies more specifically to families engaged in agriculture. And then there is Chapter 7, which is best described as liquidating all assets to satisfy debtors, with the intention of discharging most debts.
Part of business lending is to assure we only lend to businesses that can remain a going concern, which typically means they show the strong ability to remain solvent. Events that can lead to insolvency can be quick and unpredictable, so it is important the business is well capitalized and carries the appropriate insurance. Insolvency can lead to bankruptcy, in which it will be challenging to be repaid timely, if at all.