Question

This is a discussion board question.

Explain the concept and provide an example if needed (ex. journal entry, depreciation calculation, t-account, statement).

Solvency analysis focuses on the ability to accompany to pay its liabilities. It is usually assessed using the following:

1.     Current position analysis

2.     Accounts receivable analysis

3.     Inventory analysis

4.     The ratio of fixed assets to long-term liabilities

5.     The ration of liabilities to stockholders’ equity

6.     The number of times interest charges are earned

Answer 1

Solvency ratios are primarily used to measure a company's ability to meet its long-term obligations. In general, a solvency ratio measures the size of a company's profitability and compares it to its obligations. By interpreting a solvency ratio, an analyst or investor can gain insight into how likely a company will be to continue meeting its debt obligations. A stronger or higher ratio indicates financial strength.

Currnet position analysis : Current position measures a company's ability to pay its current liabilities (payable within one year) with its current assets such as cash, accounts receivable and inventories. It helps the company to understand the financial impact of the company in case of solvency analysis.Even if the year‑end current ratio is very strong, interim ratios may reveal that the company is dangerously close to insolvency. for example a current ratio much higher than 2 to 1, while implying a superior coverage of current liabilities, can signal a wasteful accumulation of liquid resources.

Account Receivable analysis : The average accounts receivable turnover measures in effect the speed of their collection during the period. The higher the turnover figure, the faster the collections are, on average. The collection period (or days' sales in accounts receivable) measures the number of days' sales uncollected. It can be compared to a company's credit terms to evaluate the quality of its collection activities.

Inventory Analysis : Inventories are not always reported as current assets. Specifically, inventory amounts in excess of current requirements should be excluded from current assets. Current requirements include quantities to be used within one-year or the normal operating cycle, whichever period is longer. Business at times builds up its inventory in excess of current requirement to hedge against an increase in price or in anticipation of a strike. Such excess inventories beyond the requirements of one year should be classified as noncurrent. The inventory turnover ratios give us a measure of the quality as well as of the liquidity the inventory component of the current assets. The quality of inventory is a measure of the company's ability to use it and dispose of it without loss.

The ratio of fixed assets to long term liabilities : In the case of fixed assets, there is the possibility of their inclusion in current assets under one condition. The condition is that management intends to sell these fixed assets and management has a definite contractual commitment from a buyer to purchase them at a specific price within the following year (or operating cycle, if longer). Fixed Assets to long term liabilities ratio provides the long term plans of an organisation.