What solvency is, and why your bank balance can't tell you

Solvency is one thing and nothing else: more money coming in than going out, and making enough of it. To know whether you have it, you need two numbers: the cash you actually hold, and what you owe at this moment.

The rule everything else comes from

The source states the rule in a single line, written in capitals: “The first rule of finance and any activity is income greater than outgo.”

On a first read it sounds too obvious to bother with, and that is exactly why people skip past it. Any business owner will agree with it. Ask most of them whether it was true for their own business last month, though, and they cannot say, because nobody measured it.

A second source boils the same idea down to two moves. Earn as much as you can, and spend less than you earn. That, it says, is the basic alphabet of keeping control of money.

Turnover, income and profit are three different numbers

The usual confusion starts when a month with high turnover feels like a good month.

Suppose a heating and air-conditioning installer turns over $42,000 in a month and spends $39,000. He keeps $3,000, and he still feels it was an excellent month, because so much went through the business.

Now suppose a consultant turns over $18,000 in the same month and spends $6,000. Her turnover is less than half of his, and she made four times as much.

Turnover is not income, and income is not profit. Those are three separate figures, and only the last one ends up paying you.

What solvency actually is

The source defines the word without any fog. Solvency, meaning your ability to pay what you owe, is made of exactly two things: income greater than outgo, and earning enough money. The same definition also says how it is measured, by comparing cash with bills, which the source calls the cash-bills ratio.

There is no hidden third ingredient. In practice, the answer sits in two figures you can write on a scrap of paper: the cash that is genuinely available to you today, and the sum you have to pay now. Once you have both, you have the answer. You do not need an accountant or software for it, and it takes a few minutes.

Suppose a garage owner has $60,000 sitting in the bank against $85,000 of current liabilities, meaning payments that are due now. The account looks healthy, and he has no money.

The opposite case is a freelance designer with $9,000 in the bank and no debt at all. Her account looks thin, and she has money.

That is also why the bank balance on its own misleads you. It is a real number, yet it leaves out what you already owe, and it leaves out what you have earned but not yet been paid.

Financial planning is not finding money

Most people assume financial planning is about getting money from outside: a loan, a grant, an investor. The source rules that out in so many words and puts a different question in its place: “FP is ‘how do we stay solvent?’”

FP is simply the source's shorthand for financial planning. In small-business terms, planning your money means arranging what you already have so that the business keeps going.

The source then adds a qualifier that stops the illusion before it forms. Planning is the second step. The first step is making the money, and no amount of planning will repair the neglect of that first step.

Suppose a contractor spends two months on a detailed budget. His income does not move, because no cell in the spreadsheet ever sold anything. Had he spent those two months calling potential clients and planned on the back of an envelope, he would have been better off on both numbers.

A polished budget for money that does not exist yet is an exercise in imagination. You make it first, and plan it after.

What happens when nobody measures

When you do not hold on to this rule, you look at the numbers that feel good. Turnover is up, the bank balance seems fine, and the owner is sure the business is doing well.

Suppose an IT consultant brings in $45,000 a month and spends $47,000. That is not a business, yet she feels she is doing better than a clinic owner who earns $22,000 and spends $20,000. What separates them is not the size of the sums, but the ratio between what comes in and what goes out.

The source puts this through a character in a Dickens novel. Someone with a little more than he spends lives in happiness, and someone with a little less lives in misery. The gap between them is tiny, and it decides everything.

So the question is never how much passes through your hands. It is whether more comes in than goes out, and whether you have enough to pay what is due now.

The booklet gives this chapter two short exercises, called measure and diagnose. In the practice section at the end of the booklet you will also find one called the two numbers, and another called the weekly ritual.

Whether you have money is not answered by a glance at the balance. It is answered by two numbers, and by one rule that everything else comes from.

The booklet is general knowledge, not financial advice for your business.