Business solvency measurements are good data to have to ensure the financial health of your business. These measurements tend to evaluate data as of a point in time, such as the fiscal year end. This data is then subjected to numerous analyses to evaluate how well a company is performing, as well as how strong financially it is (including measuring the businesses solvency).
Needless to say, this list of business solvency measurements is by no means complete, as Wall Street would attest. However, the following measurements represent the basics in understanding business solvency:
Net working capital: Total current assets less total current liabilities equals the net working capital of a business. Generally speaking, a positive figure should be present for most businesses.
Current ratio: Total current assets divided by total current liabilities equals a company’s current ratio. A ratio of greater than one to one should be present.
Quick or acid‐test ratio: Total current assets is reduced by inventory and other current assets (such as prepaid expenses, deposits, and so on) and then divided by total current liabilities to produce the quick or acid‐test ratio. The higher the ratio, the better, but having a ratio of less than one to one is often common, especially for companies with significant levels of inventory.
Debt‐to‐equity ratio: Total debt (current and long term) divided by the total equity of the company equals the debt‐to‐equity ratio. Higher ratios indicate that the company has more financial leverage, which translates into more risk being present.
Days sales outstanding in trade accounts receivable: Trade receivables divided by average monthly sales multiplied by 30 days produces the days sale outstanding in trade accounts receivable figure. Lower numbers with this calculation are usually positive because it indicates a company is doing a good job of managing this asset and not consuming excess capital.
Be careful when using average monthly sales, because companies that are growing rapidly or that have significant seasonal sales want to use an average monthly sales figure that is more representative of recent business activity.
Days costs of goods sold outstanding in inventory: Inventory divided by average monthly costs of goods sold multiplied by 30 days produces the days costs of goods sold outstanding in inventory figure. Lower numbers with this calculation are usually positive because it indicates a company is doing a good job of managing this asset and not consuming excess capital.
As with days sale outstanding in trade accounts receivable, be careful when using average monthly costs of goods sold, because companies that are growing rapidly or that have significant seasonal sales want to use an average monthly costs of sales figure that is more representative of recent business activity.
Debt service coverage ratio: Interest and depreciation expense are added back to the net income (or loss) of a company, which is then divided by the current debt service (defined as interest expense plus the current portion of long‐term debt plus any outstanding balance with a current line of credit facility termed out over a reasonable period) to produce the debt service coverage ratio. A ratio of greater than one to one is desired and indicates that a company generates enough free cash flow to cover its debt service.
