Business bankruptcies increased 40.4%, from 13,481 to 18,926, from 2022 to 2023, according to statistics released by the Administrative Office of the U.S. Courts. Solvency opinions may help creditors determine whether a liquidating debtor can meet repayment obligations. They also 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 for guidance.

The basics

Solvency is generally defined as a business’s or individual’s ability, at a specific point in time, to meet 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 repay their debts because the fair value of assets might include non-liquid assets.

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.

3 tests

Valuators apply the following three tests to analyze solvency:

1. Balance sheet test. This test determines whether, at the time of the transaction at issue, the debtor’s asset value exceeded its liability value. The balance sheet is just a starting point for the test.

For purposes of this test, assets are generally valued at fair market value, rather than at book value. The latter is less relevant because it’s typically based on historic cost, and fixed assets (such as vehicles and equipment) may be reduced by annual depreciation expense. In addition, 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. So, adjustments may be needed to amounts shown on the balance sheet to more accurately reflect the fair market value of assets.

Other appraisal specialists may sometimes be hired to determine the fair market value of certain assets, such as real estate, equipment and intellectual property. Adjustments also may be required for unrecorded contingent assets and liabilities.

2. Cash flow test. This test examines whether the company has 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 and projected costs.

A valuator’s analysis 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. Valuators also look at various financial metrics, such as debt-to-equity, current and quick ratios.

3. Adequate capital test. This 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, a valuator 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 operating expenses, capital expenditures and debt repayment obligations.

In Conclusion

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 valuation expert can perform a comprehensive solvency analysis that covers all the bases and will stand up in court.