Solvency explained

Solvency is a company’s ability to pay its debts.

You can quickly measure solvency by comparing a company’s assets with its liabilities.  If liabilities exceed assets, then the company is probably insolvent.

Regrettably, the balance sheet does reliably measure the value of assets. Many assets are measured at historical cost.  If you paid $200,000 for a piece of land in 1980, then the land would usually remain valued at $200,000 on your balance sheet.  In the US, accountants cannot record any increases in value.  Therefore, many assets on the balance sheet may be undervalued while others could be overvalued.

Suppose that land which cost $200,000 is now worth $20 million.  The balance sheet would list it at $200,000.  As you test the company for solvency (assets minus liabilities), then, you will discover that the company appears insolvent.  However, when you figure in the appreciation of the land, the company is just fine.

Solvency is not easy to measure.

[Image: US Mint]

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