Abstract: Solvency is generally defined as a business’s or individual’s ability, at a specific point in time, to meet its long-term interest and repayment obligations. A company’s solvency may come into play in fraudulent conveyance, bankruptcy alter ego and due diligence actions. This article highlights the three tests that experts apply when preparing a solvency opinion. All three of these tests must be passed for a company (or debtor) to be considered solvent.
3 tests to analyze solvency
Solvency is generally defined as a business’s or individual’s ability, at a specific point in time, to meet its long-term interest and repayment obligations. To determine whether a business is solvent, both the federal Bankruptcy Code and the Uniform Fraudulent Transfer Act look at the fair value of a debtor’s assets.
The company (or debtor) is determined to be solvent when the fair value of assets is greater than its debts. This may seem straightforward, but sometimes the waters get muddy. For example, some companies may be legally solvent but nonetheless unable to pay their debts because the fair value of assets might include nonliquid assets. Here’s a closer look at what factors into a solvency opinion.
A company’s solvency may come into play in fraudulent conveyance, bankruptcy alter ego and due diligence actions. When questions arise about solvency, the parties often call on a business valuation expert to prepare a solvency opinion. A solvency opinion is an independent professional analysis that questions management’s assumptions and projections. Obtaining an accurate, authoritative solvency opinion is essential because transactions made during an insolvency period can be voided by a court.
Experts consider several key issues to determine solvency:
- Does the company have positive equity (that is, do assets exceed liabilities)?
- Is the company able to pay off debts as they come due?
- Does the company possess adequate capital to operate?
With these questions in mind, the expert then applies three tests to analyze solvency.
Balance sheet test
The first test determines whether, at the time of the transaction at issue, the debtor’s asset value exceeded its liability value. Assets are generally valued at fair market value, rather than at book value. The latter is typically based on historic cost, and fixed assets (such as vehicles and equipment) may be reduced by annual depreciation expense.
The balance sheet is just a starting point for this test. Book value is an accounting concept, and — under the principle of conservatism — the value of some assets may be understated on a balance sheet prepared under U.S. Generally Accepted Accounting Principles (GAAP). So, adjustments may be needed to amounts shown on the balance sheet to more accurately reflect the fair market value of assets.
In addition to business valuation experts, other appraisal specialists may sometimes be hired to determine the fair market value of such assets as real estate, equipment and intellectual property. Adjustments also may be required for unrecorded contingent assets and liabilities.
Cash flow test
The second test examines whether the debtor incurred debts that were beyond its ability to pay as they matured. It involves analysis of a series of projections of future financial performance. Such projections are developed by varying some key operating characteristics of the business, such as revenue growth.
In his or her analysis, an expert considers a range of scenarios. These include management’s growth expectations, lower-than-expected growth, and no growth — as well as past performance, current economic conditions and future prospects.
Experts also look at various financial metrics when applying the cash flow test. Examples include the debt-to-equity, current and quick ratios.
Adequate capital test
This final test determines whether a company is likely to survive in the normal course of business, bearing in mind reasonable fluctuations in the future. In addition to looking at the value of net equity and cash flow, experts consider other relevant factors, such as asset volatility, debt repayment schedules and available credit.
When assessing how much capital is reasonable, an expert may consider the company’s historic performance (before its solvency came into question) and industry norms. The capital adequacy test is passed if the debtor corporation is expected to have sufficient cash on hand to pay its 1) operating expenses, 2) capital expenditures, and 3) debt repayment obligations.
All or nothing
A company must pass all three of these tests to be considered solvent. Courts usually will presume that a company (or debtor) is insolvent, unless it can prove otherwise. A comprehensive solvency analysis performed by a credentialed valuation expert can provide objective support for managerial decisions based on forward-looking financial statements.