Business Studies
Solvency
All businesses need to assess how they are performing and solvency is indication of this.
This Revision Bite shows you how to use simple calculations to assess solvency.
Working capital
A business is solvent if it can meet its short-term debts when they are due for payment. To do this it needs adequate working capital [Working capital: The difference between current assets less current liabilities - the difference between a firm's cash and its short-term debts - the money it has to play with. ].
There are 3 main reasons why a business needs adequate working capital. It must:
- pay staff wages and salaries
- settle debts and therefore avoid legal action by creditors
- benefit from cash discounts offered in return for prompt payment
You can calculate a firm's working capital by using the following equation:
working capital = current assets [Current assets: Anything which could be converted into cash within 12 months. Current assets can include bank accounts, cash, stocks of raw materials and finished goods. They can also include debtors ie those who owe the business. ] minus current liabilities [Current liabilities: Any debt which has to be paid within 12 months. Current liabilities include all creditors, bank overdrafts and other expenses. ]
Many groups of people are interested in the published accounts of a company. The information they provide may influence future decisions. For example, lenders will be looking at the solvency [Solvency: The ability of a business to pay it's short term debts. ] of a business.
Typical exam question
You may be given a case study in the exam and be asked to calculate a firm's working capital. Here is a typical example.
- Question
Go-Faster Sports is a high street retailer dealing in sports equipment. Look at its balance sheet below and calculate its working capital.
- Answer
£25,000 working capital
Current ratio
Lenders need to know that Go Faster will be able to repay any credit they are given in the short-term. The company provides information on its ability to meet its short-term debts by publishing its current ratio [Current ratio: The ability to meet short-term debts. ]. This assesses how many times it could afford to pay its current liabilities out of its current assets. Here is the equation you should learn:
current ratio = current assets/ current liabilities
- Question
Now look at Go Faster Sports Balance sheet and calculate its current ratio using this formula.
- Answer
You will see that it is:
£30,000 / £5,000 = 6 / 1 = 6:1
This ratio shows us that it could afford to pay its liabilities six times from its current assets.
Acid test / liquid assets ratio
Another measure of a company's liquidity is the acid test/liquid assets ratio [Acid test/liquid assets ratio: The ability to meet short-term debts without selling stock. ]. This deducts the value of currently held stock to find the company's ability to meet its liabilities immediately. Stock is the least liquid current asset so it is deducted to give a more realistic view of the company's liquidity.
Learn this equation. You may be asked to calculate the acid test ratio in an exam.
Acid test / liquid assets = current assets - closing stock / current liabilities
- Question
Now look at Go Faster Sport's balance sheet and calculate the acid test / liquid assets ratio.
- Answer
£30,000 - £15,000 / £5,000 = £15,000 / £5,000 = 3 / 1 = 3:1
This shows us that Go Faster can afford to pay their short-term debts three times over immediately without selling any stock.
Now try a Test Bite