Solvency

Solvency is a subject that can be challenging for our clients and can cause some distress when not understood correctly. This is not a very festive subject, but it's important to address it during these uncertain times we are currently going through.

What is a solvent company versus an insolvent company?
A solvent company is one that has the ability to meet its long-term debt and financial obligations. On the other hand, an insolvent company is one that is not able to meet these obligations. 

As a general rule, an insolvent business is not allowed to continue trading and incurring additional debt with creditors, unless it meets certain criteria (illustrated with an example below).

If solvency appears to be an issue once financial statements are prepared at the end of the financial year, prudent accountants will raise this with their clients. Unfortunately, the actual word ‘solvency’ sounds alarming, and of course in some circumstances, it could legitimately be cause for concern.  

In many cases, however, it does not mean that your business is at imminent risk of failing. So your first step is to seek clarification and understanding before pressing the panic button. 

Negative equity versus insolvency
Sometimes a company can carry negative equity according to its statement of financial position (i.e. the business has liabilities that exceed the accounting value of the assets), but have legitimate reasons for this. In this situation, the entity would not be considered insolvent. (Or rather, it is technically insolvent according to the financial statements, but only temporarily due to the nature of the business and its plans moving forward.) 

It is probably easiest to illustrate this with an example. 

Example 
Luke, Tom, and Ashleigh have a property investment company, which purchases a rental property in a popular area with good prospects for capital growth. Under zoning rules, the property has the potential to be developed and have six townhouses built on it. 

They rent the existing house on the site to tenants, but this does not generate sufficient rental income to meet the costs of owning the property (e.g. rates, insurance, interest). Because of this, the shareholders (Luke, Tom, and Ashleigh) need to support the company out of their own pockets. However, they know that as time goes on, the solvency position will improve significantly because the value of the property will increase. 

When annual financial statements are prepared, they only reflect the value of the property when it was purchased (not its present value). Therefore on paper, the company appears to be insolvent due to its current liabilities, which include money owed to the shareholders, exceeding the accounting value of the assets. However, when the property is revalued at a later date and its new value reflected in the financial statements, the equity position is revealed as positive. In other words, the company is not insolvent (and, in reality, never has been except from an accounting perspective). 

Liquidity versus solvency
Liquidity is another factor to take into consideration. 

Liquidity is a business’s ability to meet its short-term financial obligations, e.g. annual insurance costs, money owed to suppliers. 

Solvency, on the other hand, is the ability to meet long-term obligations, such as longer-term loan payments. 

If the business has more debt than assets, it is considered insolvent, even if it has high liquidity and is able to meet its shorter-term financial obligations. 

What should you do if your financial statements say your company is insolvent?
Firstly, if your accountant brings to your attention that your company is insolvent according to the financial statements, contact them to seek clarification. 

It does not necessarily mean that your business is about to be put into liquidation. 

As explained above in the property company example, often there is no cause for alarm because in reality, the value of the assets exceeds the liabilities of the company. 

In other cases, the liabilities are loans the shareholders have made to the company, and so it is very unlikely you’d call in those loans and make your company truly insolvent. However, it is an alert that you might need to put some measures in place. 

On rare occasions, a company could truly be on the verge of liquidation, and you should seek immediate help to manage this in the best possible way. 

Summary
A financially healthy company will have good short-term liquidity and long-term financial solvency, which is of course what we wish for all of our clients. 

If you are concerned about the solvency position of your business, there are two things you should not do: 1) panic, or 2) bury your head in the sand and ignore the issue. 

What you should do is seek help from experts in this area. Please contact us at GRA if you would like to discuss this further, or if you require assistance in relation to the solvency of your business.