Solvency is defined as the ability of a business to meet its long-term financial obligations. It is a key measure of how well a company is doing currently and if it will be able to manage its activities into the future.
A solvent company can pay all its liabilities when they fall due, as well as being free from legal action or threats from creditors. Conversely, an insolvent company may have cash flow difficulties, more liabilities than assets or be facing creditor pressure. Company directors must regularly assess their firm’s financial position for both the short and longer-term. This can be shown via a solvency ratio test, a method frequently used by accountants to ensure a company is viable.
It is based on the calculation of net business income plus non-cash expenses divided by all business liabilities to equal the solvency ratio. When expressed as a number, the higher the score, the more solvent a business is seen to be. In contrast, the lower the score, the more insolvency is a risk.
Why is Solvency so Important for a Business?
A business that is solvent, showing growth, and managing its risks will be viewed favourably and should benefit from more competitive borrowing terms, for example.
But matters can change and even if the business has its wage bill, tax, and supplier costs under control, directors should be regularly scanning the horizon for events that could impact their solvency.
There is a raft of external issues that could deplete profits such as regulatory changes, litigation against the business, more competition, or an unforeseen change in trading conditions.
There may be a need to change focus, potentially invest more in technology or other items, restructure, bring in new people or reduce headcount and expenses – it is these key decisions, if taken at the most opportune time, that set the course for success or failure.
All businesses face threats, but firms with the ability to counter these and plan ahead are often those that thrive without growth, the business stagnates and may eventually become insolvent.
Company Dissolution – why Solvency Matters
Solvency is not of critical importance for those firms which continue to trade. Closing a business is also easier if it is solvent. This can take place via dissolution, also known as ‘striking off’ and which means removing a firm from the Companies House register. It is generally the lowest cost and easiest way of ending a business, but it can only occur if no debt exists or if liabilities can be settled in full within 12 months.
What is a Declaration of Solvency?
This is a document that is signed by the directors of a company as part of a Members’ Voluntary Liquidation process (MVL). An MVL is a liquidation process that is only available to solvent companies.
The directors sign a document – shortly before the MVL is initiated – to swear that the company is solvent, which guarantees that the business is able to pay off any outstanding debts and interest within a period of no more than a year from the start of the liquidation. The document needs to be witnessed by a lawyer. The Declaration of Solvency is completed alongside another document called the statement of assets and liabilities, which details the company’s financial standing and it will also endorse a proposed liquidator. If there are two directors or fewer, then all should sign and where there are more than two, then a majority can sign. The Declaration of Solvency should be made no earlier than five weeks before the winding-up resolution is made by company shareholders.
It should be noted that if the business is actually insolvent and the directors still sign the Declaration of Solvency, then this constitutes a criminal offense. This is the case whether or not the directors are aware of the financial position and they risk being fined, barred from holding directorships, or even jailed.
Because of this, directors should take time to thoroughly check that they have no future liabilities, such as an impending legal case or an employment tribunal, which could mean a large fine and might tip the business into insolvency.