Financial equilibrium is a situation in which a company is able to meet all its debts within the agreed terms. Thus, it shows that its management is efficient.
To know if there is a financial balance, analysts should review the company’s financial statements, particularly the balance sheet.
Financial equilibrium conditions
The main conditions of financial equilibrium are:
- Liquidity: It means that the current assets of the company are greater than its current liabilities. If this is true, there are more than enough resources to pay off debts in the short term.
To ensure liquidity, a working capital can be created, defined as the part of current assets financed with long-term debt.
- Solvency: Measures the ability of a firm to repay the obligations contracted. Unlike liquidity that focuses on the immediate future, solvency focuses on a longer-term horizon.
To find out if a company is solvent, you can use the solvency ratios. For example, we have the debt ratio of total assets (Total liabilities / Total assets), whose value should ideally be between 0.4 and 0.6. If it falls below that range, the firm may benefit from financing with more third-party resources. On the other hand, if the ratio exceeds 0.6, the firm’s debt is high, so it is in danger of facing solvency problems.
- Financing non-current assets with permanent resources: The company must make its long-term investments, such as the purchase of machinery, with permanent resources (belonging to equity or non-current liabilities). This implies that the life time of the acquired fixed asset coincides with the term of the debt used to finance it.
If the above is met, the company should not put its non-current assets at risk to pay off short-term loans.
See relationship between profitability, risk and liquidity
Types of financial equilibrium
The types of financial equilibrium are as follows:
- Normal financial balance: Current assets are greater than current liabilities. Under this condition, the company can pay off its financial obligations in the short term.
- Financial imbalance or instability in the short term: Current assets are less than current liabilities, so the company may be forced to suspend payments in the immediate future. To avoid this situation, you can take measures such as selling fixed assets, increasing the share capital, among others.
- Bankruptcy: The total liability is greater than the total assets of the firm. That is, the net worth is negative. This circumstance produces the liquidation of the company to return the debt to the creditors.
Example of financial balance
Let’s look at an example of financial equilibrium. Suppose that a company presents the following balance sheet:
|Active||Passive and heritage|
|Non-current assets||120,000||Non-current liabilities||130,000|
In this case, the company presents a normal financial balance because current assets are greater than current liabilities. However, it is striking that the debt ratio of total assets is 0.81. This was calculated as follows:
Total assets: Current assets + Non-current assets = 150,000 + 120,000 = 270,000
Total liabilities: Current liabilities + Non-current liabilities 130,000 + 90,000 = 220,000
Total Assets Debt Ratio = Total Liabilities / Total Assets = 220,000 / 270,000 = 0.81
The above means the company is capable of meeting its obligations in the short term. However, it could have solvency problems in the long term because more than 80% of its assets have been financed with resources from third parties.