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Solvency | Definition | Calculation (with Example) - YouTube
Channel: WallStreetMojo
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hello everyone hi welcome to the channel
of WallStreetmojo or watch the video
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till the end also if you are new to this
channel then you can subscribe us by
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clicking the bell icon. Friends we are
going to learn an important topic that's
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called solvency. One of the most
important thing that every company is
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looking for so let's understand see
solvency is the ability of the firm to
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continue that service this is a very
important word to continue its
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operations for a longer period of time
so the whole concept is to continue the
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operations for a deep perpetual period
of time you can say so what exactly is
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the solvency well. Solvency is basically
the ability of the firm to continuous
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the operation for a longer period of
time so in simple terms solvency
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basically ensures whether a firm is
it's not enough to pay
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off its long-term debt so the basic difference between the
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liquidity and the solvency is all about
the firm's ability to pay off its
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short-term debt so in the case of
liquidity or long-term debt in case of
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the solvency so here instead of taking
the company's example we'll try to
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understand the solvency from an
individual perspective for taking
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individual perspective will ease
remember one thing what we are doing is
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we are trying to learn the individual
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perspective over here the individual
perspective is going to ease of the
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process as an in an investor who is
investing in to come his individual
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individually would be able to understand
when to go for big investment and when
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to retreat. So let's take a solvency
example let's say there is a guy called
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mr. Gordon
who wants to invest in a company his
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friend basically told him that it's a
very good idea to invest into a
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particular company since the company is
doing quite well but mr. Gordon he isn't
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sure whether he has enough money to get
into something so he goes to
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one of his friends who invests into the
company the friend tells him to look at
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the solvency of the individual account
so what exactly comes up
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I'm going to bifurcate over here as
assets which is the first thing which
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includes your cash, house, car, and any
other assets
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cash let's say if this is 50,000,
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$200000, $15000 and $10000.
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So this are the assets this is
what he is going to look forward to then
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there is liability any let's say
educational loan
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for his let's say for his first child
that he must have taken let's say $30,000
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then the mortgage on the house if any he has taken let's
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say $100000 credit card debt if any
which is let's say $20000. So
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mr. Gordon now we know he decides to
find out how much total assets he owns
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and how much total liability he has to
pay off so the total asset over here
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cash, house, car, other assets
which will give us about total assets
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our total asset is going to be all is
equal to which is $275000 and then
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we have the liabilities so our total
liability
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is going to be $150,000
right this is our total. So now
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mr. Gordon wants to know his net worth
so his investor friend mentions after
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that after liquidating his assets
and liability if mr. Gordon sees that he
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is still left with a positive net
worth he should go ahead and invest in
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that particular company and his another
friend suggested so if mr. Gordon finds
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that his net worth that is your net
worth if he is net worth is negative
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then it's better to first to pay off all
its additional debt so mr. Gordon deduct
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his total liability from the total asset
and comes up with the following so
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the net worth goes something like this
is equal to your bracket the total
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assets less the total liability so your
total assets is equal to $275,000
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your total liability $150,000
which gives you your $125,000.
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as the net worth so from the
above calculation mr. Gordon gets clear
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idea about what he should invest in a
company right now or not since his net
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worth is positive and he would have a
healthy amount in his pocket even after
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paying off all his all he owes he
decides to go ahead with his investment.
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Now let's understand the solvency of a
company.
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now if you're running a business you
want to invest into a project or buy a
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chunk of shares you if you want to in a
new startup so first you need to find
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out how much the net worth
how much the net worth of the of your
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company has if your company is
liquidated immediately can your company
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be able to survive for some time at
least I would say sometime at least so
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for example, the approach would be a bit
different because in the case of the
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companies you need to think you need to
think through of fixed expenses okay the
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fixed expenses your variable expenses
every month and your production costs,
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serving costs and so on and so forth so
as a company owner you
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need to make sure that you have at least
six months to one year of working
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capital ready before investing in any
new project
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so plus based on this you require
additionally the company can use
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debt to equity ratio
the de ratio and any interest coverage
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ratio to find out whether the
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firm is able to pay its long-term
debt or not. Now the debt to equity ratio
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would tell the company that whether its
equity if its equity is enough to pay
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off its debt rate or else the form can
check its income statement and can find
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out the ebit and the interest charge
for the debt payment and they will
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get an idea about whether they have
enough earnings before interest in taxes
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to pay off the interest payment for a
debt however whether to invest in a
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project or not is completely a different
ballgame altogether so that's it for
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this particular topic if you have
learned and enjoyed watching this video
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