Solvency is one of the key measures when it comes to gauging financial management of a farm.
“Financial risk can be broken down into three main financial management parameters — solvency, liquidity, and profitability,” said provincial farm finance specialist Rick Dehod. “Once the measure within each of these three financial parameters has been assessed, the overall financial health and exposure to financial risk in a farming operation can be determined.”
Solvency is defined as having enough value in the form of assets in a business to cover all of its liabilities. The financial equation is: Assets = liabilities + equity.
“A business with positive equity is said to be solvent,” said Dehod. “When a business’s equity becomes negative it’s said to be insolvent. Bankruptcy is just around the corner for an insolvent business if it doesn’t generate enough cash flow income to meet its debt requirements in a timely manner.”
The larger the amount of equity (assets minus liabilities), the more financially secure a business is.
“But everything is relative. Larger businesses need more equity to remain viable than smaller businesses do,” said Dehod.
Solvency ratios depend on the type of farm enterprise.
“Supply-managed industries can carry higher financial risk and survive in the long term as their income is secure and frequent. Thus, they have less profitability risk, and can carry greater solvency risk.”
Solvency takes on added importance during “lean years,” he added.
“A farm with strong equity can absorb a loss and continue to operate,” he said. “A farm that has leveraged its equity through debt can provide greater returns on equity when times are good but can quickly be at risk when the farm runs into difficulties.
“Knowing your solvency and your farm’s ability to manage risk will provide you with the information to manage your business and protect or grow your equity.”