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Solvency is an important factor for a company’s financial health. Measuring solvency ratios gives professional insights as to how the company is performing and how efficiently the company is paying off its debt and interest. Solvency ration measures the company’s ability to meet its future debt obligations while remaining profitable.
Solvency Ratio is a financial metric that measures a company’s ability to cover long term liabilities and shows how efficient it generates cash flow to meet future debt obligations. It indicates the financial health of a business and help investors managers and shareholders better evaluate profitability.
The first factor is cash flow. When measuring this companies account for depreciation and expenses to understand financial capacity. When measuring solvency professionals also consider all debt obligations instead of only a company’s short term liabilities.
How is Solvency Ratio Calculated ?
Solvency Ratio consist of various metrics that all measure financial consistency in long term debt repayment, accrued interest tax deferments and outstanding shares using cash flow and assets. There are various ways to calculate solvency but the main formula for calculating solvency ratio is as follows :
Solvency Ratio = (Net Income + Depreciation) / All Liabilities (Short-term + Long-term Liabilities)
Here 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. Solvency 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 these ratios allows interested parties to assess the stability of the company’s capital structure.
Types of Solvency Ratio
- Debt to Equity Ratio
Debt to equity is one of the most used debt solvency ratios. The debt to equity ratio measures how much debt a company uses to fund its operations in comparison to equity. When a company uses its debt to pay for ongoing business activities, it is necessary to monitor equity to ensure this value is substantial enough to cover debts should the company need to liquidate. So the higher the ratio, the higher the debt value is to fund a company’s growth. It is represented as Debt to equity ratio =Long term debt/shareholders fund
2. Debt Ratio
Debt ratio is a financial ratio that is used in measuring a company’s financial leverage. It is calculated by taking the total liabilities and dividing it by total capital If the debt ratio is higher it represents that the company is riskier. It 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.
3. Proprietary Ratio or Equity Ratio
Proprietary Ratio establishes relationship between the proprietors funds and the net assets or capital. It is expressed as
Equity/Proprietary Ratio = Shareholders Fund/Capital or Shareholders fund/Total Assets
4. Interest Coverage Ratio
The interest coverage ratio is used to determine whether the company is able to pay interest on the outstanding debt obligations. It is calculated by dividing company’s EBIT with the interest payment due on debts for the accounting period.
It is represented as
Interest coverage ratio = EBIT/ Interest on long term debt
Where EBIT= Earnings before interest or taxes
A higher coverage ratio is better for the solvency of the business while a lower coverage ratio indicates debt burden on the business.
5. Interest Coverage Ratio
With the interest coverage ratio the investor can determine the number of times the company’s profit can be used to pay interest charges on its debts. To calculate the figure we have to divide the company’s profits by its interest payments. The higher the value, the more solvent the company. It is calculated as
Interest coverage ratio = EBIT/Interest on long term debt
A higher coverage ratio is better for the solvency of the business while a lower coverage ratio indicates debt burden on the business.
This is was all about the solvency ratios that determine the solvency of a business organisation by measuring its ability to pay long term debt obligations.
6. Financial Leverage
Financial Leverage is the use of debt to buy more assets. Leverage is employed to increase the return on equity. However an excessive amount of financial leverage increases the risk of failure since it becomes more difficult to repay debt.
The financial leverage formula is measured as the ratio of total debt to total assets. Financial leverage is favorable when the uses to which debt can be put to generate returns greater than the interest expense associated with the debt.
Difference Between a Solvency Ratio and a Liquidity Ratio
Basis for Comparison | Liquidity | Solvency |
Definition | Liquidity is defined as the business’ ability to pay off current liabilities with current assets | Solvency measures the business’ ability to meet its debts as they fall due for payment |
Obligation | Short-term liabilities | Long-term obligations |
What It Describes | How easily assets are converted to cash | How well the business sustains itself in the long run |
Ratios | The ratios that measure the liquidity of a business are known as liquidity ratios. These include current ratio,acid test ratio, quick ratio etc. | The solvency of the business is determined by solvency ratios. These are interest coverage ratio, debt to equity ratio and the fixed asset to net worth ratio |
Risk | The risk is pretty low. However, it might affect the creditworthiness of the business | The risk is extremely high as insolvency can lead to bankruptcy |
Balance Sheet | Current assets, current liabilities and detailed account of every item beneath them | Debt, shareholders’ equity and long-term assets |
Impact on Each Other | If solvency is high, liquidity can be achieved within a short period of time | If liquidity is high, solvency may not be achieved quickly |
Is a High Solvency Ratio Good?
A high solvency ratio is usually good. It means company is usually in better long term health compared to companies with lower solvency ratios. On the other hand, a solvency ratio that is too high may show that the company is not utilizing potentially low cost debt as much as it should. While solvency is mostly used as a barometer of financial health and higher is good.
Is Solvency the Same as Debt?
Solvency is related to debt, as solvency is the measurement of how well a company will be able to pay off its debts. In lot of cases, it makes sense for a company to borrow money. In a lot of cases, it makes sense for a company to borrow money. In other cases, it may be cheaper to take on debt rather than issue a stock . In the long run however it is important that a company keeps track of its future obligations and whether it will be able to pay long term debt.
Limitations of Solvency Ratios
Solvency ratio is a useful measure but somewhere it has some short falls too. It does not factor the 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.
Conclusion
A high solvency ratio indicates 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 etc.
