What is the Solvency Ratio?
All funds on which a company runs do not come directly from the owners. Companies usually take a debt in the form of loans, debentures, and deposits to manage the business. These debts have to be repaid along with the interest in the long-run. Solvency is the ability of the firm to keep up with its debt obligations.
Solvency ratios are crucial components of financial analysis and assist in determining whether a company has enough cash flow to manage its debt obligations. If a company has a low solvency ratio, then it indicates that it is at more risk of defaulting its debt repayment.
Solvency ratios are used by a prospective lender for evaluating the solvency state of a business. Companies having a higher solvency ratio are more likely to meet their debt obligations. A solvency ratio of 0.5 is considered to be good.
Solvency Ratio = Net profit + Non Cash expenses / Short term liabilities + Long term liabilities
- Solvency ratios assess the long-term health of a company by evaluating its long term debt and interest accrued on that debt
- Solvency ratios are not the same as liquidity ratios; liquidity ratios determine the capability of a company to manage its short-term liabilities
- A company with high liquidity can easily meet sudden financial emergencies but doesn’t indicate if a company can easily honor all its debt obligations in the long run. Conversely, a company on solid ground for the long term may or may not be able to manage a sudden crash crunch.
Types of solvency ratio:
The solvency ratio is estimated from the components extracted from the income statement and balance sheet of a company. Debt solvency ratio components are taken from the balance sheet whereas coverage solvency ratio parameters are taken from the income statement.
Here are the various kinds of debt solvency ratios commonly used.
Debt to equity ratio (D/E):
This ratio is calculated by dividing the company’s total liabilities with the shareholder’s equity. These values can be taken from the financial statements of a company. It is a crucial metric used to evaluate a company’s financial leverage. It also makes it clear if the shareholder’s equity has the potential to cover all the debts in case a company is going through a rough time.
DE=Total Debt / Total Shareholder's Equity
Alternatively, you can also use the following solvency ratio equation for estimating the D/E ratio
DE=Total Liabilities / Total Shareholder's Equity
A high D/E ratio indicates the company is using debt to rapidly fuelling its growth rate and also hints towards lower solvency.
Debt to Capital Ratio (D/C):
The debt to capital ratio is a financial ratio used for measuring a company’s financial leverage. It is estimated by taking total liabilities and dividing it by total capital. If the ratio is higher, then it indicates that the company is riskier. Long-term debts include notes payable, bonds payable, bank loans, etc.
DE = Total Debts / Total Capital
A low D/E ratio indicates that the business is stable while a higher ratio raises doubt about its long-term stability. Trading on equity is also possible with a higher D/E ratio.
Total Debt to Total Asset Ratio:
This debt ratio defines the total amount of debt owed by a company to its total assets. This ratio reflects the financial stability of a company. A high ratio indicates high risk for investors who are looking to make investments in a company. It also indicates that the major assets are financed by debt.
Total DebtTotal Assets = (Short Term Debt + Long Term Debt) / Total Assets
Creditors use this solvency ratio formula to determine the total debts owed by a company.
How to calculate the solvency ratio?
Analysts use several solvency ratios to determine if a business is of high risk or profitable for investors. The formulas have been mentioned in the previous section. The various variables can be extracted from an income statement or balance sheet to evaluate the solvency ratio and study the financial health of a company.
Let us take an example of two companies operating in the same industry which is wholesale grocery. Based on the current financial information, we will estimate which one has a better solvency ratio.
|Short Term Liabilities
|Long Term Liabilities
DE = Total Debt / Total Shareholder's Equity
Shareholder’s Equity = Total Assets – Total Liabilities
For Company Alpha,
DE = 1,86,801 / 5,41,450 = 0.345
For Company Beta,
DE = 2,70,729 / 3,57,526 = 0.75
With the D/E ratio of Alpha being 0.345 it implies that the company is using $0.345 in debt for every $1 of equity. The industrial average for the sector is around 1.5. Both the companies taken in the example have higher ratios than the industry average thereby indicating that both are risky.
How do solvency ratios work?
A low solvency ratio raises a red flag for analysts. If multiple solvency ratios point to low solvency that it indicates that there is a major issue. A company struggling with solvency in a good economic environment indicates that it is unlikely to fare well in the future.
A low solvency ratio indicates business owners that it should put an effort into reducing the debt, increasing its assets, or work on both. Potential investors can learn that there are serious problems ahead and the stock price could plunge in the future. Traders can take a low solvency ratio as a sign to short the stock.
What is a good solvency ratio?
Acceptable solvency ratios vary from one industry to another. If we take the general rule of thumb, a solvency ratio of greater than 20% is believed to be financially healthy for any company. The lower the ratio, the greater is the probability that the company will default on its debt obligations.
Importance of solvency ratio:
Companies need to make it a habit to check their solvency ratios periodically to check their financial health. It also helps businesses to evaluate their capital structures and determine if they need to redistribute their external and internal equities. These ratios will also affect their decision to take on more debt down the line.
Calculating solvency helps companies make firm financial decisions and ensure profitability in the long run. They also reassure shareholders and creditors that your company can pay off its debts.
A good solvency ratio varies from one industry to another. It is crucial to compare the numbers with the competitors to determine where a company actually stands amidst the competition. For instance, technology companies have higher insolvency ratios in comparison to utility companies.
The solvency ratio is a crucial parameter that assists in determining the financial status of the company. The ratio measures the ability of a firm to satisfy its long-term obligations. It also closely targets the investors for understanding and appreciating the ability of a business to meet its long-term liabilities. It is a vital parameter for decision-making ability.
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