A solvency ratio is a performance metric that helps us examine a company’s financial health. In particular, it enables us to determine whether the company can meet its financial obligations in the long term.
The metric is very useful to lenders, potential investors, suppliers, and any other entity that would like to do business with a particular company. It usually compares the entity’s profitability with its obligations to determine whether it is financially sound. In that regard, a higher or strong solvency ratio is preferred, as it is an indicator of financial strength. On the other hand, a low ratio exposes potential financial hurdles in the future.
The solvency ratio helps us assess a company’s ability to meet its long-term financial obligations.
To calculate the ratio, divide a company’s after-tax net income – and add back depreciation– by the sum of its liabilities (short-term and long-term).
A high solvency ratio shows that a company can remain financially stable in the long term.
How to Calculate the Solvency Ratio
As explained later, there are a couple of other ways to determine a company’s solvency, but the main formula for calculating the solvency ratio is as follows:
Solvency Ratio = (Net Income + Depreciation) / All Liabilities (Short-term + Long-term Liabilities)
If you examine keenly, you will notice that the numerator comprises the entity’s current cash flow, while the denominator is made up of its liabilities. Thus, it is safe to conclude that the solvency ratio determines whether a company’s cash flow is adequate to pay its total liabilities.
Let’s look at the case of SaleSmarts Co.:
SaleSmarts (USD in millions)
Solvency Ratio = (45,000 + 15,000) / (83,000 + 160,000)
Solvency Ratio = 0.246 * 100 = 24.6%
Important to note is that a company is considered financially strong if it achieves a solvency ratio exceeding 20%. So, from our example above, it is clear that if SalesSmarts keeps up with the trend each year, it can repay all its debts within four years (100% / 24.6% = Approximately four years).
Limitation of the Solvency Ratio
Although the solvency ratio is a useful measure, there is one area where it falls short. It does not factor in a company’s ability to acquire new funding sources in the long term, such as funds from stock or bonds. For such a reason, it should be used alongside other types of analysis to provide a comprehensive overview of a business’ solvency.
Other Solvency Ratios
Financial ratios enable us to draw meaningful comparisons regarding an organization’s long-term debt as it relates to its equity and assets. The use of ratios allows interested parties to assess the stability of the company’s capital structure. Here are a few more ratios used to evaluate an organization’s capability to repay debts in the future.
1. Debt-to-Equity (D/E) Ratio
Often abbreviated as D/E, the debt-to-equity ratio establishes a company’s total debts relative to its equity. To calculate the ratio, first, get the sum of its debts. Divide the outcome by the company’s total equity. This is used to measure the degree to which a company is using debt to fund operations (leverage).
2. Interest Coverage Ratio
With the interest coverage ratio, we can determine the number of times that a company’s profits can be used to pay interest charges on its debts. To calculate the figure, divide the company’s profits (before subtracting any interests and taxes) by its interest payments.
The higher the value, the more solvent the company. In other words, it means the day-to-day operations are yielding enough profit to meet its interest payments.
3. Debt-to-Capital Ratio
As implied in the name, the debt-to-capital ratio determines the proportion of a business’ total capital that is financed using debt. For example, if a company’s debt-to-capital ratio is 0.45, it means 45% of its capital comes from debt. In such a case, a lower ratio is preferred, as it implies that the company can pay for capital without relying so much on debt.
Before an individual or organization invests or lends money to a company, they need to be sure that the entity in question can remain solvent over time. Thus, interested stakeholders utilize solvency ratios to assess a company’s capacity to pay off its debts in the long term.
A high solvency ratio is an indication of stability, while a low ratio signals financial weakness. To get a clear picture of the company’s liquidity and solvency, potential investors use the metric alongside others, such as the debt-to-equity ratio, the debt-to-capital ratio, and more.
Thank you for reading CFI’s guide to Solvency Ratio. To keep advancing your career, the additional CFI resources below will be useful: