Solvency ratio and your business

What is solvency and why is it important?

A solvency ratio shows the relationship between equity (private money) and total assets. This simple calculation determines if your business can meet its debts in the long term. A higher solvency ratio can be seen as a financial buffer if your business is ever in trouble.

Equity capital is the difference between your business's assets and debts. Total equity consists of equity capital and debt capital. Loan capital is money your business has borrowed.

Financial resilience

Solvency gives insight into the resilience of your business. A high solvency ratio means your business is in a strong financial position. You are less dependent on external lenders because your investments are mainly covered by your business activities. The sale of your assets will be enough to pay creditors if anything goes wrong.

A high solvency ratio gives business partners and suppliers more security. They see that you can pay them. It is also important for financing. A higher solvency ratio means a financier carries less risk. Your business may even receive a lower interest rate.

How do you calculate your solvency ratio?

Use this formula to calculate the solvency ratio of your business:

• (Equity / Total assets) x 100% = Solvency ratio

Your equity is the value of assets in your business minus liabilities.

Your total assets include both equity and loan capital (the money your business has borrowed).

Fixed assets are present in your company for more than a year, such as equipment or property. Current assets are present in your company for less than a year, such as inventory or money owed by customers.

Liabilities are existing debts that finance assets. These include contributed equity (own money and funds) and debt (money from third parties). Long-term liabilities have a term of more than one year. Short-term assets have a term of less than one year.

Please note: reserves are included in equity capital. Provisions are under foreign equity.

Balance sheet and profit & loss

The balance sheet in your annual accounts shows your equity and total assets. Together with your profit and loss account, the balance sheet forms the financial statements. Think of this as a snapshot of the assets, liabilities and equity in your business at a single moment. It is a snapshot because the balance sheet changes daily: a debtor pays, you purchase goods or pay taxes. You can see this on your interim balance sheet and your profit and loss statement.

Look at your accounts once a month to calculate your solvency ratio. Track the changes over time to gain more insight into the financial fitness of your business.

An example solvency ratio calculation

If your equity is €50,000 and your total assets are worth €150,000, your solvency ratio is:

• (50,000 / 150,000) x 100% = 33%

What is a good solvency percentage?

Financiers consider a good solvency percentage to be between 25% and 40%. Besides solvency, other calculations or ratios together give a picture of your company's financial situation. Every company and industry has their own characteristics that influence the financial outlook. Having a lot of cash usually has a positive effect. A large inventory that is difficult to sell has a negative effect. Financiers are attracted to a high solvency ratio as the risk of being unable to repay a loan is smaller. The standard for solvency that financiers use differs per industry, per type of business and per financier. In the KVK Book of Finance, you can find more about calculations or ratios and how financiers use them.

Improve your solvency

Depending on your situation there are various ways to improve your solvency. A financial advisor can help you find the best solution for your business. Consider these options:

• Ask your customers to pay on time. Fewer outstanding invoices mean more money in your account. You will borrow less for working capital. As the loan capital on your balance sheet decreases, your solvency ratio increases.
• Consider factoring. Pre-financing invoices reduce the number of days you wait for invoices to be paid and the number of outstanding debtors.
• Optimise your inventory. Money is locked up in your goods until they are sold. The smaller your inventory, the lower your total assets. Lower total assets with the same equity mean a higher solvency ratio.
• Ask your supplier for a discount if you pay quickly. This gets you a higher return on surplus cash.
• Distribute less profit (dividends). Keep profit in your company and add it to the general reserves. This increases equity.
• Increase your profits. Extra profit means more equity. Increase your income or cut costs for higher profitability. Be critical of your purchasing and sales prices.
• Consider sale and leaseback. Some assets, such as equipment, can be sold and leased back to you. If you make a book profit, your equity increases. You can also use this money to pay off debts.
• Invest your own money in the business. In a sole proprietorship, general partnership (vof) or limited partnership (cv), you can invest private money in your business. This increases your equity. In a private limited company (bv), you can buy shares in your business or provide a loan. You can subordinate the loan to a creditor, such as a bank. A financier sees this as 'liable bank capital'. If debts have to be settled, any money owed to the bank is paid first.