Table of Contents Hide
- What is a Solvency Ratio?
- How To Calculate The Solvency Ratio
- Types of a Solvency Ratio
- #4. Equity to Debt Ratio
- Solvency Ratio Examples
- Liquidity Ratios vs. Solvency Ratios
- Problems with Solvency Ratios
- Solvency Ratio FAQs
- What is the most common solvency ratio?
- What are the 3 liquidity ratios?
- Why are solvency ratios important?
The solvency ratio is used to assess a company’s ability to pay its long-term liabilities, such as debt and interest on that debt. It is one of many financial ratios that can be used to assess a company’s overall health.
Continue reading for examples of how to calculate a solvency ratio with the formula, how to use them in your long-term analysis, and how these formulas differ from liquidity ratios.
What is a Solvency Ratio?
A solvency ratio is a performance metric that allows us to assess the financial health of a company. It allows us to determine whether the company can meet its long-term financial obligations.
The metric is extremely useful to lenders, potential investors, suppliers, and any other entity interested in doing business with a specific company. To determine whether an entity is financially sound, it usually compares its profitability to its obligations. A higher or stronger solvency ratio is preferred in this regard, as it is an indicator of financial strength. A low ratio, on the other hand, reveals potential financial difficulties in the future.
How To Calculate The Solvency Ratio
There are a couple of other ways to determine a company’s solvency, as explained later, but the main formula for calculating the solvency ratio is as follows:
If you look closely, you’ll notice that the numerator represents the entity’s current cash flow, while the denominator represents its liabilities. As a result, it is safe to conclude that the solvency ratio determines whether a company’s cash flow is sufficient to cover all of its liabilities.
What Is the Importance of Solvency Ratios?
Solvency ratios can paint a clear picture of a company’s financial health. A solvency ratio measures various balance-sheet items such as cash on hand, total assets, total liabilities, and equity held by company owners and investors. A solvency ratio can reveal the following:
#1. Financial leverage:
A highly leveraged company owes a large amount of debt to lenders and may have limited financial flexibility.
In order to be profitable in the long run, businesses must generate enough net income to pay off long-term debt. If operating income is insufficient to cover salaries and short-term debt, it may indicate future insolvency.
Before making a financial commitment, investment bankers try to get an accurate picture of a company’s assets and debt. An accurate solvency ratio can help reveal a company’s true value over a term.
Types of a Solvency Ratio
#1. Interest Coverage Ratio
The interest coverage ratio calculates how many times a company’s current interest payments can be covered by its available earnings. In other words, it assesses a company’s ability to pay interest on its debt during a given period.
The greater the ratio, the better. If the ratio falls below 1.5, it may indicate that a company will struggle to meet the interest on its debts.
The following is how the interest coverage ratio is calculated:
EBIT stands for earnings before interest and taxes.
#2. Debt-to-Asset Ratio
The debt-to-assets ratio compares the total debt of a company to its total assets. It assesses a company’s leverage and indicates how much of the company is funded by debt versus assets, and thus its ability to repay debt with available assets. A higher ratio, especially one above 1.0, indicates that a company is heavily reliant on debt and may struggle to meet its obligations.
This is how the debt-to-assets ratio is calculated:
#3. Debt-to-Equity Ratio (D/E)
The D/E ratio, like the debt-to-assets ratio, shows how a company is funded, in this case, by debt. The higher the ratio, the more debt a company has on its books, implying a higher risk of default. The ratio considers how much debt can be covered by equity if the company is forced to liquidate.
This is how the debt-to-equity (D/E) ratio is calculated:
#4. Equity to Debt Ratio
The equity ratio, also known as the equity-to-assets ratio, indicates how much of a company is funded by equity rather than debt. The higher the number, the healthier the business. The lower the number, the more debt a company has relative to its equity.
The following is how the shareholder equity ratio is calculated:
SER = Shareholder equity ratio
TSE = Total shareholder equity.
#5. Long Term Debt-to-Equity Ratio
This solvency ratio formula aims to determine the amount of long-term debt a business has taken on in relation to its equity and assists in determining the business’s leverage. The Ratio also identifies how much Long-term debt a company must raise in comparison to its equity contribution. Long-Term Debt refers to long-term loans obtained from financial institutions. In contrast, Equity refers to Shareholders’ Funds, which include Equity Share Capital, Preference Share Capital, and Reserves in the form of Retained Earnings.
The formula for Solvency Ratio:
#6. Total Debt-to-Equity Ratio
This solvency ratio formula aims to determine the amount of total debt (including both short-term and long-term debt) a business has incurred in relation to its equity and assists in determining the total leverage of the business. The ratio identifies how much of a company’s funding comes from debt versus equity contributions. In a nutshell, the higher the ratio, the greater the leverage, and the greater the risk due to the business’s heavy debt obligation (in the form of interest and principal payments).
The formula for Solvency Ratio:
#7. Debt-to-Income Ratio
This Ratio seeks to determine the percentage of the company’s total assets (including both current and non-current assets) that are financed by debt. It aids in determining the total leverage of the company. The higher the ratio, the greater the leverage and the greater the financial risk as a result of the business’s heavy debt obligation (in the form of Interest and Principal Payments).
The formula for Solvency Ratio:
#8. Financial Leverage
The impact of all obligations, both interest-bearing and non-interest-bearing, is captured by the Financial Leverage ratio. This ratio seeks to determine how much of the company’s assets belong to its shareholders rather than its debt holders/creditors. As a result, if the majority of assets are funded by equity shareholders, the business will be less leveraged than if the majority of assets are funded by debt (in that case, the business will be more leveraged). The higher the ratio, the greater the leverage and the greater the financial risk associated with the heavy debt obligation used to finance the company’s assets.
The formula for Solvency Ratio:
#9. Proprietary Ratio
This ratio establishes the relationship between shareholder funds and the total assets of the business. It shows how much shareholder money has been invested in the company’s assets. The higher the ratio, the lower the leverage and, consequently, the financial risk on the part of the company. In the opposite direction, it can be calculated by taking the inverse of the Financial Leverage Ratio.
The formula for Solvency Ratio:
Solvency Ratio Examples
To gain a better understanding of the solvency ratio, consider the following numerical examples:
Alpha and Beta are two companies that operate in the same industry, Leather Shoe Manufacturing, and have provided information from their balance sheet at the end of the year. Let us examine the solvency of the two businesses using the same criteria.
|Particulars||Alpha Company||Beta Company|
|Common Stock (1$ par value) (1)||$550000||$500000|
|Preferred Stock (2)||$150000||$200000|
|Retained Earnings (3)||$800000||$700000|
|Total Equity (1+2+3)||$1500000||$1400000|
|Current Assets (A)||$1500000||$1700000|
|Long Term Assets/ Non Current Assets (B)||$1500000||$1200000|
|Total Assets (A+B)||$3000000||$2900000|
|Short Term Debt (C)||$600000||$1000000|
|Long Term Debt (D)||$900000||$500000|
|Total Debt (C+D)||$1500000||$1500000|
Let’s look at the formula and calculation for the Solvency Ratios now:
The calculation for various solvency ratios is shown in the figure below.
|Ratios||Alpha Company||Beta Company|
|Long Term Debt to Equity Ratio||Long Term Debt/Total Equity=$900000/$1500000=0.6||Long Term Debt/Total Equity=$500000/$1400000=0.36|
|Total Debt to Equity Ratio||Total Debt/Total Equity=$1500000/$1500000=1||Total Debt/Total Equity=$1500000/$1400000=1.07|
|Debt Ratio||Total Debt/Total Assets=$1500000/$3000000=0.5||Total Debt/Total Assets=$1500000/$2900000=0.52|
|Financial Leverage||Total Assets/Total Equity=$3000000/$1500000=2||Total Assets/Total Equity=$2900000/$1400000=2.07|
|Proprietary Ratio||Total Equity/Total Assets=$1500000/$3000000=0.5||Total Equity/Total Assets=$1400000/$2900000=0.48|
We can draw a few interesting conclusions from the above Ratios:
The Long-Term Debt to Equity Ratio of Alpha Company is higher than that of Beta Company. Still, a lower Total Debt to Equity ratio compared to Beta indicates that Beta Company is funding itself with more short-term debt and will be more vulnerable to liquidity risks in the event that short-term interest rates fall.
Both companies have the same level of Total Debt; however, Alpha Company has less financial leverage than Beta Company due to increased equity contribution.
Liquidity Ratios vs. Solvency Ratios
Solvency and liquidity ratios are similar, but there are some key differences. Both of these types of financial ratios will indicate a company’s health. The main distinction is that solvency ratios provide a longer-term perspective on a company, whereas liquidity ratios focus on the short term.
Solvency ratios examine all of a company’s assets, including long-term debts such as bonds with maturities of more than a year. In contrast, liquidity ratios examine only the most liquid assets, such as cash and marketable securities, and how they can be used to cover upcoming obligations in the short term.
Problems with Solvency Ratios
The main issue with solvency ratios is that there is no single ratio that provides an accurate picture of a company’s solvency. Instead, these ratios must be supplemented with additional data to gain a more complete understanding of an organization’s ability to consistently pay its bills on time. This entire set of data must then be compared to similar data for the rest of an industry to determine how well a company compares to its peers.
Another issue with solvency ratios is that they do not take into account a company’s ability to obtain new long-term funding, such as through the sale of stock or bonds. These ratios also do not take into account the existence of existing lines of credit that can be used to obtain additional funding on short notice. When a company has a large, primarily untapped line of credit, it can easily pay its bills even if its solvency ratios paint a bleak picture of its ability to pay.
The third issue with these ratios is that they provide no insight into new lines of business that a company is launching and which may be generating significant positive cash flow. In contrast, the ratios do not reveal whether existing investments are performing poorly, resulting in low returns on investment (if any). These issues are significant because they can have an immediate impact on a company’s solvency.
Before an individual or organization invests or lends money to a company, they must be confident that the entity will remain solvent in the long run. Thus, interested stakeholders use solvency ratios to assess a company’s ability to repay its debts over a term.
A high solvency ratio indicates financial stability, whereas a low ratio indicates financial weakness. Potential investors use the metric alongside others, such as the debt-to-equity ratio, the debt-to-capital ratio, and others, to get a clear picture of the company’s liquidity and solvency.
Solvency Ratio FAQs
What is the most common solvency ratio?
The most common solvency ratios include the equity ratio, the debt ratio, and the debt to equity ratio.
What are the 3 liquidity ratios?
The current ratio, quick ratio, and cash ratio are the three most important liquidity ratios.
Why are solvency ratios important?
Solvency ratios assess a company’s ability to meet its long-term debt obligations. Calculating solvency ratios is an essential part of assessing a company’s long-term financial health and stability.