Solvency is the ability of an organization to pay for its long-term obligations in a timely manner. If it cannot marshal the resources to do so, then an entity cannot continue in business, and will likely be sold or liquidated. Solvency is a core concept for lenders and creditors, who use financial ratios and other financial information to determine whether a prospective borrower has the resources to pay for its obligations. The debt to equity ratio and the times interest earned ratio are among the more commonly used metrics for making a determination regarding solvency.
Solvency can also be considered difficult to maintain based on a non financial event. For example, a company that relies on an income stream from patent royalties may be at risk of insolvency once the patent expires. Continued solvency can also be a concern when a business loses a lawsuit from which the damages are considered to be significant, or regulatory approval is not obtained for a business venture.
When the management of a company is deciding whether to finance operations with additional debt or equity, the risk of insolvency is one of its key considerations. When a business operates in a low-profit environment where monthly results are highly variable, it is at greater risk of insolvency, and so should be more inclined to finance operations with additional equity.