ACCOUNTING FINANCIAL STATEMENTS – Part 6 – Solvency
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As a matter of fact, the general purpose of the financial statements is to provide information about the results of operations, financial position, and cash flows of an organisation. This information is used by the readers of financial statements to make economic decisions regarding the allocation and reallocation of resources.
Therefore, in this article we highlight the features of two important financial concepts: Solvency and Insolvency, one leading to the other. We advise our readers to watch these concepts and take necessary good steps to manage their solvency stage and guard against insolvency.
READ ALSO: ACCOUNTING FINANCIAL STATEMENT – LIMITATIONS
What is solvency?
Solvency is the ability of an organisation to pay for its long-term obligations in a timely manner. If it cannot marshal the resources to do so, then an entity cannot continue in business, and will likely be sold or liquidated.
Solvency is a core concept for lenders and creditors, who use financial ratios and other financial information to determine whether a prospective borrower has the resources to pay for its obligations. The debt to equity ratio and the times interest earned ratio are among the more commonly used metrics for making a determination regarding solvency.
Solvency can also be considered difficult to maintain based on a non financial event. For example, a company that relies on an income stream from patent royalties may be at risk of insolvency once the patent expires. Continued solvency can also be a concern when a business loses a lawsuit from which the damages are considered to be significant, or regulatory approval is not obtained for a business venture.
Relationship with Debt Financing:
When the management of a company is deciding whether to finance operations with additional debt or equity, the risk of insolvency is one of its key considerations. When a business operates in a low-profit environment where monthly results are highly variable, it is at greater risk of insolvency, and so should be more inclined to finance operations with additional equity.
What then is Insolvency?
Insolvency is a condition in which an entity cannot pay its bills as they come due for payment. In this situation, the entity first meets with its creditors and lenders to see if the obligations coming due can be restructured. Restructuring involves delaying payment and/or reducing the amount owed. If these discussions do not resolve the issue, the entity may need to be declared bankruptcy.
Therefore, an entity is considered to be insolvent when the amount of its liabilities exceeds the market value of its assets. Insolvency is also considered to have occurred when a person or business is unable to pay obligations when due. This condition may be caused by poor cash planning, poor management, or an unexpected financial loss. A likely outcome of insolvency is negotiations with creditors to reduce or defer payments, or bankruptcy.
Business Silent Killers
Has your business run out of cash? Businesses can often run for years before a cash flow problem suddenly emerges, leaving you unable to pay staff, suppliers and other creditors essential to your business’s continued operations.
Could the loss of an important staff member affect your business’s ability to continue trading?
If your business is generating a steady profit every month, it can be very tempting to assume that nothing could possibly go wrong and threaten its financial stability and solvency.
Businesses fail for a wide range of reasons. Sometimes, competition slowly erodes a business’s hold over its market, reducing its profits. In other cases, businesses fail in a rapid, surprising fall that catches everyone – including the director – off guard.
Insolvency can often occur suddenly, leaving your business in a difficult position and forcing you to consider options such as administration or liquidation. Even “sudden” insolvency, however, is often the result of long-term problems in your business.
In summary, we have been writing on Accounting Financial Statements, and started from the definition to the major component of financial statements. We had also taken time to explain their importance and those who use them. A major reason for preparing your financial statements regularly and honestly is to avoid Insolvency. We advise you always read our articles as an on-line business coach and the knowledge you gain will help you do well in your business. Do not hesitate in calling on us for your business financial, accounting, auditing, taxation and other financial information needs.
READ ALSO: USES OF FINANCIAL STATEMENTS
Summarised Steps to watch
What we diccussed above is hereby summarised. As an entrepreneur watch out for the following which can cause insolvency, leading to liquidation.
- Poor cash management
- The sudden loss of a line of credit
- Customers not paying in a timely manner
- The bankruptcy of a major costumer
- A sudden increase in expenses
- A sudden decline in revenues
- Lack of proper long term cash flow planning
- Excessive borrowing to fuel business growth
- Risky, unreliable business strategy or investment
- Loss of a key staff.
Founder/Managing Partner of Complete Full Marks Consultants Ltd. An Economist turned Chattered Accountant and Tax Practitioner with over 37 years of industrial experience.