If you are preparing to sell your business, understanding your solvency ratio can make a significant difference in how buyers view your long term financial strength.
This article is Part One of a two part series designed to help you understand what the solvency ratio is, why it matters, and how it shapes buyer perception.
In this first part, we focus on the core concepts and the solvency definition so you can build a clear foundation.
Once you finish this article, you can continue with Part Two, where we explore what a good solvency ratio looks like, how to improve it before you sell, and how buyers use it during due diligence.
If you prefer to start with part two and focus directly on improving your valuation and strengthening your financial story, you can access it here.
Both articles together will help you understand your financial position and prepare for a strong and confident sale.
What Is the Solvency Ratio
The solvency ratio measures the long term financial strength of your business by comparing what the company earns to what it owes.
In simple terms, it shows whether your business can comfortably meet its long term obligations using the profits it generates.
While many business owners focus mostly on short term liquidity, buyers place equal importance on solvency because it reflects true financial resilience.
The solvency definition focuses on a company’s ability to continue operating for many years without running into financial strain.
A high solvency ratio tells buyers that your business does not rely too heavily on debt and that it generates enough income to support its commitments.
A lower ratio signals greater vulnerability, which often raises concerns during due diligence.
For example, imagine two companies with the same revenue and similar assets.
One has long term debt that is modest and well managed.
The other is carrying heavy long term loans that take a large portion of yearly income to service.
Even if both companies look strong on the surface, their solvency ratios will reveal a different story.
Buyers nearly always prefer the company with the stronger solvency ratio because it represents lower risk and more stable long term potential.
In many cases, improving your solvency ratio before selling can increase your valuation because it shows buyers that the business is solid, dependable, and prepared for sustainable growth.
When you understand the ratio and present it clearly, you help buyers feel safer investing in your company, which can lead to higher offers and smoother negotiations.
Why the Solvency Ratio Matters When You Are Selling Your Business
When you begin preparing your business for a sale, the solvency ratio becomes one of the clearest indicators of long term stability that buyers look for right away.
It helps them assess whether your company can comfortably manage its long term financial commitments without creating unnecessary pressure on future cash flow.
Since buyers are essentially investing in the future of your company rather than its past, the solvency ratio provides a snapshot of how financially safe that future looks.
A strong solvency ratio reduces buyer anxiety because it shows that your business is not dependent on aggressive borrowing or risky financing structures.
It signals that your income levels are strong enough to cover existing obligations and still leave room for growth.
This gives buyers a sense of certainty, which usually translates into stronger offers and faster negotiations. Buyers are willing to pay a premium for a business that feels stable, scalable, and low risk.
A weak solvency ratio, on the other hand, can create doubts.
Buyers may worry that they would need to inject additional capital to maintain operations or restructure debt. These concerns often lead to slower deal progress, heavier due diligence requests, or reduced valuation offers.
Sometimes, if the ratio appears too risky, buyers may walk away altogether.
The solvency ratio also influences how buyers secure financing for the acquisition.
Lenders prefer businesses with strong solvency because it reduces the overall risk of the deal.
If your ratio is healthy, buyers can secure more favourable financing terms, which improves their willingness to meet your asking price.
Understanding the Solvency Definition in Simple Terms
Solvency refers to the long term financial health of a business.
A solvent company can pay its long term debts, continue operating in a stable way, and withstand unexpected challenges without running into financial trouble.
In other words, solvency tells buyers whether your business has the strength to thrive year after year rather than just performing well in the short term.
Buyers rely on this concept because they want reassurance that the business they are acquiring has enough earning power and resource stability to cover future obligations.
They do not want to inherit a company that looks profitable today but may struggle in the next few years due to heavy debt or limited long term assets.
Here are two simple examples that make the solvency definition easier to understand.
Company A earns $600,000 per year and has long term liabilities of $1,500,000.
Even though the company is profitable, its earnings may not be high enough to comfortably cover long term debt over time.
This situation raises questions about long term resilience.
A buyer may see Company A as profitable today but financially pressured in the future.
Company B earns $800,000 per year and has long term liabilities of $1,000,000.
Even though Company B earns only slightly more than Company A, it carries significantly less long term debt.
This means it is more capable of meeting future obligations without straining the business.
Buyers typically see Company B as more attractive because it represents lower long term risk and stronger financial stability.
These examples show how solvency goes far beyond surface profitability.
It highlights the relationship between what a business earns and what it owes over time.
A strong solvency position makes buyers feel confident, while a weaker solvency position often leads to deeper scrutiny during due diligence.
How to Calculate the Solvency Ratio
Calculating the solvency ratio is much simpler than most business owners expect.
The formula compares net income and depreciation to total liabilities.
Net income shows the true profit after expenses.
Depreciation is added back because it is a non cash expense that reduces accounting profit but does not reduce actual cash available to service debt.
Total liabilities include all long term financial obligations that the business must eventually pay.
Here is the formula written in simple terms:
Solvency ratio = (net income + depreciation) / total liabilities.
This calculation helps buyers see whether the business produces enough earnings to cover long term debt.
A higher ratio means the business generates more income compared to what it owes, which signals strength and stability.
A lower ratio suggests that debt levels may be too high relative to earnings, which increases long term risk.
Here are two examples that illustrate how this works:
Company A has net income of $500,000, depreciation of $150,000, and total liabilities of $2,000,000.
Using the formula, the solvency ratio is $650,000/ $2,000,000, which equals 0.32.
This indicates that Company A earns only thirty two percent of what it owes in long term liabilities each year.
Buyers may view this as a sign that the company could struggle in the long term if income does not grow.
Company B has net income of $700,000, depreciation of $200,000, and total liabilities of $1,500,000.
The solvency ratio is $900,000/ $1,500,000, which equals 0.6.
This shows that Company B earns 6% of its long term liabilities each year.
Buyers tend to see this as a healthier and more manageable position.
These examples demonstrate why the solvency ratio is so valuable.
It gives a straightforward, numerical way for buyers to understand long term financial strength.
The clearer and stronger your solvency ratio appears, the more confident buyers will feel when evaluating your business.
Final Thoughts
Understanding the solvency ratio and the solvency definition gives you a strong foundation as you prepare to sell your business.
These concepts help you see your company through the eyes of a buyer and give you the clarity you need to present your financial position with confidence.
Knowing what the solvency ratio represents and how it is calculated is the first step toward building a financial story that supports a higher valuation.
Part One focused on the meaning of solvency, why this ratio matters during a sale, and how buyers interpret the basic numbers.
Now that you have a solid grasp of these fundamentals, you will get the most benefit by continuing to Part Two of this series.
In Part Two, you will learn what a good solvency ratio looks like, how to improve your ratio before going to market, how buyers use it during due diligence, and how to turn it into a powerful negotiation asset that strengthens your value story.
If you want to take your preparation to the next level and understand how to use your solvency ratio to maximise your selling price, continue to Part Two here.
