Solvency
A firm's ability to meet long-term obligations — commonly measured by debt-to-equity, debt-to-assets, or interest coverage ratios.
On the exam, solvency questions usually hand you a balance sheet plus an income statement and ask you to compute and interpret a ratio, or to pick which firm carries more long-run default risk. The classic trap is the liquidity-versus-solvency swap: a current or quick ratio answers short-term bill-paying, never solvency — if the stem says “long-term obligations” or “interest payments,” the right ratio is debt-to-equity, debt-to-assets, financial leverage (average total assets ÷ average total equity), or interest/fixed-charge coverage. Mind the direction: higher coverage is better, higher debt ratios are worse — so the “more solvent” firm shows the lower debt-to-equity and the higher coverage.
Distinguish solvency from leverage: leverage is the cause (using debt), solvency the consequence (can you service it). A firm can raise leverage yet stay solvent if EBIT covers interest comfortably. Historically, off-balance-sheet operating leases hid debt and flattered leverage ratios; under IFRS 16 (single lessee model, 2019) and ASC 842 (operating/finance split retained), most leases now sit on-balance-sheet as a right-of-use asset and lease liability — so reported leverage rose with no change in the underlying business.
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