Which financial statement should you examine first if you are interested in assessing solvency?

A structured analysis of a company’s financial statements involves three steps:
• step one: assess if the company is ‘liquid’ (liquidity is the ability of the company to convert its assets into cash)
• step two: assess if the company is ‘solvent’ (solvency is the ability of the company to pay its debts as and when they fall due)
• step three: assess the ‘profitability’ of the company.
If the first two steps indicate an organisation that is not solvent or liquid, then an examination of its profitability will indicate whether a restructuring or some form of rescue is worthwhile.
The company would possibly be taken into the administration process if it cannot convert debtors’ balances into cash, pay its obligations when due (payroll and accounts payable) and service its long-term debt (loans and bonds). If any of these conditions occur, it would be of limited value to analyse the ability of a company to generate profits. In such circumstances, it would be of more value to analyse the ability of a company to realise its assets for cash so as to pay its outstanding liabilities.
Step one: assess liquidity
• Of the three primary financial statements (the balance sheet, the income statement and the statement of cash flows), which one should you examine first to complete a liquidity assessment?
Of the three primary financial statements, the statement of cash flows is likely to tell you something directly about the sources of liquidity.
• Does any financial statement tell you something indirectly about liquidity?
The answer is yes and, as you will soon see, two financial statements do tell you something indirectly about liquidity:
o the income statement (profit and loss account)
o the balance sheet (also known, as you have learned already in Session 3, as the ‘statement of financial position’).
The answers to the questions above are determined by the factors on which financial sustainability depends. If you are prepared to accept a definition of financial sustainability as a company’s ability to continue in the ordinary course of business while considering the demands of its stakeholders, then you need to identify the stakeholders.
Financial stakeholders such as lenders and other creditors expect to be paid monies due to them and in a timely fashion.
Determining liquidity
Step one of a structured financial analysis is about determining the ability of the organisation to convert its assets to cash. This ability can be termed liquidity. The statement of cash flows provides direct information about the liquidity of an organisation, whereas the income statement and the balance sheet (statement of financial position) provide indirect information about liquidity. For example, the income statement shows us revenues. We can combine that information with the receivables figures on the balance sheet to calculate of those revenues, how much was actually received in actual cash flow. This same information is also shown directly on the cash flow (albeit as part of the ‘cash from operations’). What we earn (revenues) can be quite different from what we receive in cash terms. Appreciating this difference can be vital to understanding an organisation’s liquidity.
Step two: assess solvency
Once you have assessed a company’s liquidity, do you need to analyse further? While completion of step one may have enabled you to assess the ease with which a company can convert its assets into cash, that determination has not allowed you to assess the ability of a company to honour its liabilities as and when they fall due. This ability is known as solvency. Consider the following questions that are relevant to developing your thinking about solvency assessments.
• Which financial statement should you examine first if you are interested in assessing solvency?
The financial statement that would be most relevant for assessing solvency is partly determined by the financial statement in which liabilities are recorded.
• What is the relevant financial statement for a solvency assessment?
The balance sheet would be relevant for a solvency assessment. Amounts owed to lenders and other creditors are recorded in the balance sheet as short-term (‘current’) liabilities and long-term (‘non-current’) liabilities.
• Does any other financial statement tell you something about solvency?
Ask yourself where a company’s long-term ability to pay debts arises. Surely a company can pay its debts only after realising an operating profit, or, more accurately, collecting cash from sales in order to pay its suppliers and payroll and to service its debt obligations. In the short term, of course, it could try new borrowings or share issues to help cash flow. But ultimately the company must become profitable to be able to generate sustainable cash flows.
Determining solvency
Step two of the financial analysis is about determining solvency of a company. To determine solvency you will need to examine both the balance sheet (focusing on liabilities payable) and the income statement (focusing on the sufficiency of revenues and profits to pay suppliers and payroll and to meet debt obligations).
Step three: assess profitability
So far, having completed steps one and two, have you addressed the needs and concerns of shareholders? In steps one and two, you attended to the demands of other stakeholders such as debtors and creditors, but shareholders are neither debtors or creditors.
• Shareholders expect to be paid any dividends at each financial year-end, but where does a company find the money to pay as dividends?
A company is permitted to pay dividends from a financial account found in the balance sheet known as the ‘retained profits’ (or ‘revenues reserves’) (it is in the shareholders’ equity section of the balance sheet).
The question that arises now is this: how does the retained profits reserve get credited – that is, how are retained profits increased over time? The answer is by net profit after taxation each year.
When a company makes a profit, it will transfer that profit from the income statement, where the profit figure will first appear, to its balance-sheet retained profits (or revenue reserve account). All this means is that shareholders have a vested interest in profitability. In the medium- to long-term, if a company does not make profits, it will not be permitted to and nor will it be able to pay dividends, unless it has previously undistributed retained profits.