Solvency explained

Solvency is a company’s ability to pay its debts.

You can quickly measure solvency by comparing a company’s assets with its liabilities.  If liabilities exceed assets, then the company is probably insolvent.

Regrettably, the balance sheet does reliably measure the value of assets. Many assets are measured at historical cost.  If you paid $200,000 for a piece of land in 1980, then the land would usually remain valued at $200,000 on your balance sheet.  In the US, accountants cannot record any increases in value.  Therefore, many assets on the balance sheet may be undervalued while others could be overvalued.

Suppose that land which cost $200,000 is now worth $20 million.  The balance sheet would list it at $200,000.  As you test the company for solvency (assets minus liabilities), then, you will discover that the company appears insolvent.  However, when you figure in the appreciation of the land, the company is just fine.

Solvency is not easy to measure.

[Image: US Mint]

About Mark P. Holtzman

Chair of Accounting Department at Seton Hall University. PhD from The University of Texas at Austin. Worked at Deloitte's New York Office. BSBA from Hofstra University.

Trackbacks/Pingbacks

  1. The balance sheet explained « Accountinator - March 28, 2012

    […] in time.  It follows the accounting equation and will help you understand a company’s solvency and […]

  2. Transparency « Accountinator - April 18, 2012

    […] reliable books.  It also requires understanding your books. Keep close tabs on your profitability, solvency, liquidity and productivity, and work to improve […]

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: