Can your business repay its debts?
This question comes up when business people are considering getting a loan, or evaluating their current financial situation. If you have a ready answer to it, plus the details that support your conclusion, you’ll be able to decide if it’s right to borrow or get supplies on credit. It may also give you a glimpse of the business’s current financial state.
But how do you answer this question?
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Solvency
In accounting, a key measure of a business’s ability to repay its debt is its solvency. Solvency is a measure that compares the size of a business’s current assets to its current liabilities and shows how much one exceeds the other. By doing this, we can establish the financial strength of the company concerned. In practical terms, it refers to a business’s ability to pay its debts.
There are two ways to measure solvency:
Quick Ratio
The quick ratio measures your business’s ability to meet its short term obligations, or cover unanticipated costs, like unexpected maintenance costs or payment for services that were previously not planned for. Note: in calculating your quick ratio, you do not include your inventory in your current assets. It’s left out. So the formula for calculating the quick ratio is:
Quick Ratio= (Total Current Assets – Total Current inventory)/Total Current Liabilities.
Here’s an example. If you have ₦20,000 in cash, and ₦200,000 in accounts receivable (money owed to you by your debtors); but you also have short term debts that sum up to ₦110,000. Your quick ratio would be:
(200,000+20,000)/110,000 =2.0.
What this means is that for every ₦1 of short term debt you have, you have ₦2 in assets. In other words, there’s more than enough to repay the debt. You’re in safe territory.
However, if you have ₦5,000 as cash in hand, ₦55,000 in accounts receivable, and debt totaling ₦100,000, your quick ratio will amount to:
(55,000+5,000)/100,000= 0.6.
That is, for every ₦1 debt you owe, you only have 60 kobo in assets. You’re currently unable to repay the debt, given what you have.
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Current Ratio
This gets beyond your business’s ability to pay and measures its overall current financial strength. As such, it incorporates elements left out in the Quick Ratio, like inventories.
It’s also a fairly good indicator of a business’s ability to pay its longer-term debt.
Current Ratio= Total Current Asset/Total Current Liability
Let’s say you have ₦200,000 in accounts receivable, ₦20,000 cash in hand, and inventory (your unsold items) worth ₦50,000. You also have current liabilities (debt) worth about ₦90,000.
Your Current Ratio will be:
(200,000+20,000+50,000)/90,000= 3.0.
In simple terms, you have assets that are worth three times your debt. All things being equal, you should be able to cover your unpaid costs.
But if the ratio falls below 1.0 (in other words, if debt exceeds total assets), your business doesn’t have enough to meet its obligations.
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