How to Judge Solvency on a Balance Sheet - dummies

How to Judge Solvency on a Balance Sheet

Solvency refers to the ability of a business to pay its liabilities on time. Your business needs to remain solvent because delays in paying liabilities on time can cause you very serious problems. In extreme cases, your business can be thrown into involuntary bankruptcy. A balance sheet can allow you to judge your business’s solvency based on these figures:

  • Current (short-term) assets include cash, marketable securities that can be immediately converted into cash, and assets converted into cash within one operating cycle.

  • Current (short-term) liabilities include non-interest-bearing liabilities that arise from the operating activities of the business. A typical business keeps many accounts for these liabilities — a separate account for each vendor, for instance.

    The terminology for accounts payable, accrued expenses payable, and income tax payable liabilities varies from business to business.

    In addition to operating liabilities, interest-bearing notes payable that have maturity dates one year or less from the balance sheet date are included in the current liabilities section.

  • Current ratio: To size up current assets against total current liabilities, you calculate the current ratio. Using information from the company’s balance sheet, you compute its current ratio as current assets ÷ current liabilities = current ratio.

    Generally, businesses don’t provide their current ratio on their balance sheets — they leave it to the reader to calculate this number.

Folklore has it that a company’s current ratio should be at least 2.0. However, an acceptable current ratio depends a great deal on general practices in the industry for short-term borrowing. Some businesses do well with a current ratio less than 2.0, so take the 2.0 benchmark with a grain of salt.