Accounting For Dummies®, 4th Edition

17.8. Look for Signs of Financial Distress

A business can build up a good sales volume and have very good profit margins, but if the company can't pay its bills on time, its profit opportunities could go down the drain. Solvency refers to the prospects of a business being able to meet its debt and other liability payment obligations on time. Solvency analysis asks whether a business will be able to pay its liabilities, looking for signs of financial distress that could cause serious disruptions in the business's profit-making operations. Even if a business has a couple billion bucks in the bank, you should ask: How does its solvency look?

Frankly, detailed solvency analysis of a business is best left to the pros. The credit industry has become very sophisticated in analyzing solvency. For example, bankruptcy prediction models have been developed that have proven useful. I don't think the average financial report reader should spend the time to calculate solvency ratios. For one thing, many businesses massage their accounting numbers to make their liquidity and solvency appear to be better than they are at the balance sheet date.

Although many accountants and investment analysts would view my advice here as heresy, I suggest that you just take a quick glance at the company's balance sheet. How do its total liabilities stack up against its cash, current assets, and total assets? Obviously, total liabilities should not be more than total assets. Duh! And obviously, if a company's ...