Introduction
Meeting financial obligations is crucial for corporations and governments. Companies earn their income through the exploitation of their existing assets and debt acquisition. Similarly, governments can utilize debts to meet their social and economic developments. While debts are significant, they can put organizations in financial crises. Consequently, the governments and companies may fail to meet their statutory obligations. Understanding the solvency ratio is significant for a financial assessment. The risk technique helps the involved party to identify their risks, therefore, encouraging the adoption of strategic measures. Unlike solvency, liquidity involves the capacity of an organization to pay its debts on time. Therefore, organizations should measure their solvency for effective financial risk management and financial planning.
The Degree of Solvency of Bay City, Texas: the Year 2016
Bay City is located in Matagorda County, Texas in the U.S., and with a population of 17, 558 in 2016. The government fiscal report for the city includes the earnings from its activities and business activities. Consequently, the city can report positive balances in all fiscal categories of the net positions for the primary government as a whole. Between the years 2015 and 2016, the city recorded a tremendous income increase. For instance, the total revenues appreciated by 6% with an increase in capital grants, contributions, and property taxes. Therefore, the city’s solvency ratios can be determined using the 2015-2016 balance sheet.
Solvency Ratios, 2016
Current Liabilities Ratio
Organizations have various financial obligations for a given period. The current liabilities are a corporation’s fiscal obligations that are due within a year or a normal operational cycle (Wassie, 2021). A cash conversational cycle, or normal operational cycle, is the duration taken by a company in purchasing an inventory and converting it to cash from sales (Cunningham et al., 2018). For instance, the amount owed to suppliers is a current liability. The current liabilities ratio is significant in determining organizational solvency and financial risk. Bay City’s current liabilities ratio is calculated by dividing the current assets by the current liabilities. The city’s current liabilities ratio is 2.7, which is higher than 1.0. The current liabilities ratio indicates that the city will have high financial stability in the following year.
Operating Ratio
Corporate management is significant for organizational success and efficiency. While many factors can be used to measure the management’s efficiency, the operating ratio is the most significant technique (Jin & Xu, 2022). The ratio helps determine management’s efficiency by comparing the total expenses of an organization to net sales (State Balanced Budget Provisions, 2010). The operating ratio determines how effective a company is at keeping costs low while generating revenues (Enright, 2021). Consequently, a smaller ratio shows more efficiency in generating revenues than total expenses. Bay City’s operating ratio for the year 2016 was 1.1. The ratio means that the capital structure of the state debt was $23, 337, 612 which is less than the value of equity. Therefore, the city has a lower ability to find higher interests charged for financing.
Net Asset Ratio
Organizations set aside cash or items of monetary value for regulatory or contractual purposes. Restricted assets involve those items or money set aside for a particular purpose. Meanwhile, unrestricted assets involve those donations to non-profit organizations that can be used for general expenses or legitimate purposes of nonprofit (Rubin, 2008). The net asset ratio is calculated by dividing the total organization’s assets by the sum of the restricted and unrestricted assets. The ratio helps in determining a corporate’s stability, and should always be high. The Bay City’s net asset ratio is 2.0, meaning that it has 2.0 times more current assets than restricted and unrestricted assets. The city has a high ability to obtain additional financing or higher interests charged for any obtained financing since the net asset ratio is more than 1.5. Therefore, Bay City’s net asset ratio of 2.0 indicates its stability over the 2017 fiscal year was sound.
Table 1.0: Bay City’s Solvency Ratios
Solvency Methods and Techniques and Why They Are Important for Government
Solvency Methods
Solvency methods involve various tools that governments and other agencies use to determine the viability of their fiscal statuses. The methods provide a concise description of the amount of money owed in an organizational capital structure, and cash flows’ capacity to cover interests, among other expenses (CFI, 2019). Therefore, solvency methods involve analysis of various financial ratios that help in examining the debt levels, and their significance in corporate growth (Hijal-Moghrabi & Sabharwal, 2018). Additionally, the ratios are crucial when a corporation’s current risk level and capital structure correlate to its debt levels. The commonly utilized financial ratios are debt-to-equity, debt-to-asset, coverage of fixed charges, and interest coverage. The solvency methods help companies measure long-term business health.
Equity Ratio
Shareholders’ equity is one of the sources of asset funding among corporations. Consequently, financial analysts use the equity ratio to determine their firms’ effectiveness in funding their assets with shareholders’ equity, as opposed to debt (Enright, 2021). The ratio is below indicate a leveraged company, while those above 0.5 are considered conservative (Enright, 2021). A conservative company is that which access more funding from shareholders’ equity than debt. Therefore, the equity ratio is significantly considered by investors who are attracted by companies and agencies that are in the conservative range since they are less risky. Lending institutions are more likely to extend credit services to conservative companies than leveraged ones.
Debt Ratio
The solvency ratio allows the companies to determine the extent of their leverage. The debt-to-asset ratio is a financial measure of its leverage extent (Jin & Xu, 2022). The ratio is calculated as a decimal or percentage expression of an institution’s total debts to total assets. Therefore, the debt-to-asset ratio is interpreted as the proportion of a corporation’s assets financed by debts. A ratio of above 1.0 or 100% shows that a company has more liabilities than assets, and it is at risk of defaulting on its loans if interest rates suddenly rise. The debt ratio varies depending on the type of industry and capital intensivist. Although the common formula of debt ratio is the total debts divided by the total assets, it can be calculated by dividing total liabilities by total assets.
Coverage of Fixed Charges
The ability of a company to cover its fixed charges such as debt payments, interest expenses, and equipment leases is crucial. The fixed-charge coverage ratio helps in determining how well a company’s earnings can help in covering the fixed expenses (Yusuf & Jordan, 2015). For instance, financial institutions look at the ratio when evaluating whether to lend money to a business or not. The ratio is calculated by dividing the sum of the earnings before interests and taxes and fixed charges before tax by the sum of fixed charges before tax and interest. Lenders use the ratio to determine a company’s cash flow for debt repayments. Consequently, a low ratio indicates that an organization is unable to make payments on fixed charges. Meanwhile, a higher ratio indicates the organization’s ability to make the payments. Therefore, the fixed-charges ratio is significant in determining a city’s financial risk.
Interest Coverage
The interest coverage ratio determines a company’s ability to cover its debts. The ratio is used by analysts and investors to examine business growth through the payment of interests on existing obligations to creditors. The interest coverage ratio is calculated by dividing earnings before interests and taxes by the interest expenses on all of the firm’s outstanding debts. Lines of credit, loans, and bonds are examples of a firm’s outstanding debts. A low-interest coverage ratio means that a company is unable to service its outstanding debts, putting it at risk of bankruptcy. Meanwhile, a high-interest coverage ratio means that the organization can service its loans. The interest coverage ratio is crucial in determining a firm’s ability to meet its loan obligations.
Advantages of the Solvency Methods to the Government
The solvency methods are beneficial to the government in various dimensions. The methods are effective tools that help analyze the government’s financial and health stability. The use of different solvency ratios gives a clear picture of financial performance among public institutions (Rubin, 2008). For instance, the equity ratio helps in determining how the government funds its assets. Meanwhile, the interest coverage ratio is significant for the government to determine its capacity in repaying loans. The utilization of the two ratios helps the analysts understand the government’s financial position. Consequently, the government may decide whether to seek loans or focus on reliable debt sustainability mechanisms.
Moreover, the solvency methods help the government in developing strategic mechanisms for financial sustainability. The debt ratios help determine the government’s financial obligations and their associated risks. Therefore, the risky financial situations would encourage the government to develop mechanisms that would help in stabilizing the economy. Meanwhile, non-risky financial situations allow the government to focus on sustainability mechanisms. Stabilizing the economy involves the utilization of existing resources to meet financial obligations such as loans (Bloch et al., 2015). Additionally, the government may resort to a debt recovery mechanism that involves changing tax rates. Therefore, the solvency methods help determine the strategic measures that can be taken by governments to overcome financial risks.
Disadvantages of Solvency Methods to the Government
Although the solvency methods help in fiscal strategic planning, they present several detriments to the government. Some of the methods are cumbersome to be used and may provide inaccurate results, leading to wrong interpretations. For instance, it is unclear which is a more accurate debt ratio formula between the use of total debts and total liabilities (Mikesell, 2018). Therefore, the use of the debt ratio may not give a true picture of the debt or liability situation. Moreover, positive solvency ratios may give an impression that governments can borrow more money from creditors (Mikesell, 2018). Although the borrowing effect may not be felt in the short term, its long-term effect may burden the citizens through hefty taxes (Yusuf & Jordan, 2015). The solvency methods can be an inaccurate measure of a government’s financial situation and may lead to overborrowing of money.
What is Solvency and How it Solves Financial Issues
Solvency involves the capacity of an organization to pay its debts. In finance and business, solvency is the extent to which a firm’s current assets exceed its current liabilities (Shieldsmith, 2020). Additionally, the concept can be described as the ability of an organization to meet its long-term fixed expenses for long-term business growth (Shieldsmith, 2020). Therefore, solvency is simply put as the debt-to-equity ratio, showing a relative proportion of total assets that are being funded by debt relative to equity (Shieldsmith, 2020). Long-term debt obligations significantly affect organizations since the businesses may be bound by agreements that limit them to conduct fiscal activities (CFI, 2019). Therefore, solvency is crucial in determining financial obligations across organizations.
Various factors affect solvency since it involves having meaningful positive equity on the balance sheet. Cash flow, expenses, profitability, and financial independence among organizations determine their solvency. Cash flow involves the net balance of money that moves in and out of business at a specific point in time (Flodén et al., 2021). While a low cash flow presents solvency problems, a high cash flow positively impacts solvency. Organizational expenses affect their solvency since they involve spending money on various business activities including debt settlement. Consequently, increased expenses negatively affect an organization’s debt-to-equity ratio. Meanwhile, financial independence exhibits an organization’s capacity to meet its obligations by its sufficient income. Low financial independence would lead an organization to borrow to meet its fiscal obligations. Firms mitigate solvency problems by ensuring high cash flow and sufficient financial independence.
Solvency is used to solve various financial issues facing organizations. Through the measure of various solvency ratios, businesses make crucial financial decisions and ensure future profitability. The debt-to-equity ratio helps companies to resort to sustainable funding mechanisms (Shieldsmith, 2020). For instace, a high debt ratio may encourage the organization to sell more prospectus to investors. Additionally, solvency is a variable indicator that differentiates a business’s financial condition (Shieldsmith, 2020). Consequently, it helps determine a company’s capability to meet long-term debts, enhancing management flexibility and financial autonomy for sustainability. Payments of debts is consistent with the Biblical teachings that it is only the wicked who borrow and do not repay (Psalms 37:21, KJV, n.d.). Therefore, solvency help organizations solve financial issues by encouraging strategic planning and effective use of available money.
Solvency vs Liquidity
Solvency and liquidity are concepts that inform organizations’ capabilities to meet their financial obligations. However, the two concepts differ in various dimensions and measures. Solvency is a company’s long-term status such as its obligation to meet financial obligations. However, liquidity helps a company’s short-term status and involves the ability to pay liabilities on time (FreshBooks, 2018). Liquidity involves the ability to easily convert assets into cash on short notice and with minimal discount. In contrast, solvency describes how well a firm can sustain itself in the long run (Aramonte et al., 2022). While liquidity is measured by current, acid test, and quick ratios, solvency is measured by interest coverage, debt to equity, and fixed asset ratios (FreshBooks, 2018). Liquidity and solvency differ in terms of their definition, measures, and description.
Moreover, liquidity and solvency differ in terms of their risk, balance sheet, and impact on each other. Liquidity puts a business at lower risk but affects its credit worthiness. Meanwhile, solvency’s risk is higher and can lead to bankruptcy (FreshBooks, 2018). For liquidity, the balance sheet has the current assets, current liabilities, and a detailed account of every item beneath them. However, for solvency, the balance sheet reflects debts, shareholders’ equity, and long-term assets. Moreover, the two concepts have different impacts on each other. For instance, if solvency is high, liquidity can be quickly achieved. In contrast, if liquidity is high, solvency may not be quickly achieved. Although liquidity and solvency measure a company’s ability to pay its debts, they present differences.
Conclusion
Solvency is crucial in determining a firm’s ability to meet its long-term fiscal obligations. The concept is measured by various methods including the debt-to-asset ratio. Governments utilize solvency to determine their financial status and identify any risk that may hinder growth. However, some solvency measures may lead to wrong interpretations due lack of a definitive formula. Solvency is different from liquidity in terms of definition, measures, description, balance sheet, risk, and impact. Therefore, liquidity and solvency are important concepts but must be distinguished.
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