Solvency - Term Overview

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Solvency is the ability of a natural or legal person to meet their financial obligations.

That is, your ability to repay, currently or in the future, the debts that you have incurred or plan to incur.

Solvency is a basic tool for a potential creditor to make decisions on whether to grant financing to the applicant, but it's also useful to know the current situation of a debtor who is currently facing his obligations.

While liquidity usually expresses the ability of companies to meet short-term financial obligations, financial solvency measures their ability to meet their obligations in the longer term.

In personal finances, solvency is usually determined by the possible delinquency of the person with respect to their present debts and by their income level. It's also important to note that guarantees are sometimes confused with solvency, when in reality they are two different concepts. This is because, although its use has a positive effect on the viability of the investment, it doesn't provide any information on the solvency of the debtor, since it only adds additional security in the event of non-payment but doesn't inform the creditor about the possibility. that this assumption ends up occurring.

How to measure the solvency of a company?

There are several ways to measure it, known as solvency ratios are the most used to calculate the solvency of a company. In addition, there are many other ways to value it, which complement these ratios.

In the case of corporate finance, it's common to use ratios, such as solvency ratios, among which the debt ratio ( total debt / total assets ) and the leverage ratio ( total assets / equity ) stand out.

Likewise, it's important to take into account liquidity, which in a colloquial way we could say that it measures short-term solvency. There are several liquidity ratios, the most widely used is the current liquidity ratio, which measures the relationship between current assets and liabilities of a company.

In the case of large companies and States, it's usually measured by rating agencies, which study a series of standardized parameters to finally decide on the solvency of the debtor in question. Based on this analysis, they determine the credit quality, that is, the quality of the debt of the corresponding company or country.

These agencies employ rating scales that gradually rate states and companies, first separating between investment grade and high yield from inability to service their debts (colloquially called " junk bond ") to the highest rating ( which is usually called "triple A" in large agencies).

This in turn has a great impact on how easy it's for companies and states to finance themselves, since the more solvent may offer lower interest rates by not having problems attracting conservative risk-averse investors. On the contrary, countries and companies with lower credit ratings will not be able to offer security to investors, and will try to attract the riskiest ones by offering them higher returns. This differential between the interests of a financial asset subject to risk and another free of it's what we commonly know as the "risk premium", and is therefore directly linked to solvency.

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