How do you discern that a company is in trouble? And when does insolvency come into play?
There are financial ratios that show how good and profitable a company are. But how troubled a company is? There are some measures for that as well.
There are two ways to be — as a company — bankrupt. You can have liquidity issues, where you do not have enough cash or operating assets to cover you immediate liabilities. You have at that point enough long term assets to cover your debts, they are just not easily accessible.
Or you can be overextended, insolvent on the balance sheet. Balance sheet insolvency comes when your assets do not cover your liabilities. Oddly enough you can operate for a long time before solvency issues catch up with you, however illiquidity is immediate and sometimes even sudden.
Basic liquidity test is a cash ratio. If you divide your cash with current liabilities, your cash ratio should tell you how much of your current liabilities are you able to cover at the time. Rule of thumb says it should be over 50 %, but that depends on your payment terms.
Slightly more robust is a quick ratio. You divide your current assets without inventories and prepayments by your current liabilities. The resulting ratio should cover about 100 %, which means that all your reasonably liquid assets can cover your liabilities.
Last liquidity test is current ratio. You get that by dividing current assets and current liabilities. If you already passed quick ratio and cash ratio, there is no real need to stress about current ratio. However if you struggle with those, you can take solace in ratios over 2.
On the balance sheet solvency side, you should always check your debt to assets ratio. If debts are higher than assets you are technically insolvent. There are many different recommendations especially for different industries and countries, but current trends are around 60-80%
You can also see this measurement in form of debt-to-equity ratio. Since equity is just assets - debt, it does tell a same story.
Another important measure is a debt service coverage ratio, which is a mouthful to say or write. You calculate it by dividing your net operating income (operating profit after taxes) by debt service, which consists of interest and principal payments. Optimize for highest possible ratio.
If you can periodically check those financial ratios, you are on track to detect early any solvency issues that could arise. Your company will be much better and safer for it.