The solvency ratio formula guides how to measure a firm’s ability to meet its long-term debt obligations. This metric is calculated from the components of the balance sheet and income statement elements. This is of great importance for investors to know because it helps in knowing about an organization’s solvency. We would outline the calculation and example of the solvency ratio.
What is solvency ratio?
A solvency ratio is a financial metric that is used to measure the ability of an enterprise to meet its long-term debt obligations. Prospective business lenders make use of it. A solvency ratio is an indicator of whether a company’s cash flow is sufficient to meet its long-term liabilities and then measures its financial health. This means that an unfavorable ratio can indicate that a company is likely to default on its debt obligations. Through this financial metric, one is able to determine whether a company can meet its financial obligations in the long run.
A solvency ratio is useful to lenders, potential investors, suppliers, and other entities that would like to do business with a particular company. Usually, it compares the entity’s profitability with its obligations to determine whether it is financially sound. With regard to this, most entities and potential investors prefer a strong solvency ratio since it is an indicator of financial strength. On the other hand, a low ratio exposes future financial hurdles.
We can say that this financial metric is one of the many metrics that is used to determine whether a company can remain solvent in the long term. In other words, a solvency ratio comprehensively measures solvency and a firm’s actual cash flow rather than net income, by adding back depreciation and other non-cash expenses to examine or assess the company’s capacity to stay afloat.
It measures this cash flow capacity against all liabilities rather than considering just short-term debt. It is through this that the solvency ratio assesses the long-term financial health of a company by evaluating its repayment ability for its long-term debt and the interest on that debt.
Solvency ratios vary across industries, therefore, a company’s solvency ratio should be compared with its competitors in the same industry instead of just viewing it in isolation.
This financial metric is also used when evaluating insurance companies, comparing their capital size in relation to the premiums written. It also measures the risk an insurer faces on the claims it is unable to cover.
The main types of solvency ratios are the debt-to-equity (D/E) ratio, debt-to-assets ratio, equity ratio, and interest coverage ratio. These measures may be compared with liquidity ratios which consider the ability of a firm to meet short-term obligations rather than medium to long-term ones.
Solvency ratio formula
Although there are different types of solvency ratios, the main solvency ratio formula is as follows;
Solvency ratio = (Net income + depreciation) / All liabilities (short-term + long-term Liabilities)
Having examined the general solvency ratio formula, the numerator comprises the entity’s current cash flow while the denominator comprises all its liabilities. With this, it is okay to conclude that the solvency ratio determines whether the cash flow of a company is adequate enough to pay its total liabilities.
Solvency ratio example
If for example, emerald Inc has the following information;
|Emerald Inc.||Amount in millions of $|
We will now calculate the firm’s solvency ratio using the solvency ratio formula;
Solvency ratio = (Net income + depreciation) / All liabilities (short-term + long-term Liabilities)
Solvency Ratio = (45,000 + 15,000) / (83,000 + 160,000)
Solvency Ratio = 0.246 x 100 = 24.6%
From the calculation, we can conclude that the firm is financially strong because it achieves a solvency ratio that is exceeding 20%. From this, if Emerald Inc. keeps up with the trend each year, it will be able to repay all its debts within four years, which is 100% divided by 24.6%.
Types of Solvency Ratios
- Debt-to-equity (D/E) ratio
- Debt-to-assets ratio
- Equity ratio (Proprietary ratio)
- Interest coverage ratio
Debt-to-equity (D/E) ratio
The debt-to-equity ratio is one of the most frequently used solvency ratios. It is similar to the debt-to-assets ratio in the sense that it indicates how a company is funded but in this case by debt. This ratio takes a look at the amount of debt that can be covered by equity if there is a need for the company to liquidate. This metric is important as it is used to evaluate a company’s financial leverage. It helps to understand if the shareholders’ equity has the ability to cover all the debts in case the business is experiencing a tough time.
A high debt-to-equity ratio has to do with a higher risk for the business as it is an indicator that the company is making use of debt to fuel its growth. In essence, it indicates lower solvency of the business.
The debt to equity ratio is calculated by dividing the company’s debt outstanding by the shareholders’ equity. These figures are obtainable from the balance sheet of the company’s financial statements. The debt-to-equity ratio formula is represented in the image below;
It is important to note that the debt-to-equity ratio can be categorized into two, The long-term debt-to-equity ratio and the total debt-to-equity ratio. The long-term debt-to-equity ratio aims at determining the amount of long-term debt a company has undertaken in relation to equity. In essence, this metric helps to identify the amount of long-term debt a business has to raise compared to its equity contribution. What changes in the formula is that only long-term debts are considered with respect to shareholders’ equity. The second one which is the total debt-to-equity ratio is aimed at determining the total debt, that is both long-term and short-term debts as represented in the image above. That is, total debt outstanding divided by equity.
The debt-to-assets ratio measures the company’s debt in relation to its total assets, both fixed and current assets. It indicates how much of the company is funded by debt against assets, that is, its ability to pay off its debt with its available assets. A higher ratio such as above 1.0 is an indicator that the company is significantly funded by debt and may experience difficulty in meeting its debt obligations.
The formula for calculating the debt-to-assets ratio is represented in the image below;
Equity ratio (proprietary ratio)
The equity ratio or the proprietary ratio is also known as the equity-to-assets ratio. It establishes a relationship between shareholders’ funds (equity) and the total assets of the business. It indicates the number of shareholders’ funds that have been invested in the assets of the business. The higher the ratio, the lesser the financial leverage of the company and comparatively less is the financial risk on the business’s part. We can calculate the equity ratio by taking the inverse of the financial leverage ratio.
The equity ratio formula is shown in the image below;
Interest coverage ratio
The interest coverage ratio is a financial metric used to determine whether the company is able to pay the interest charged on outstanding debt obligations. A higher interest coverage ratio is better for the solvency of a company. On the other hand, a lower coverage ratio indicates a debt burden on the business. It is calculated by taking the earnings before interest and taxes (EBIT) and dividing them by the interest payment due on debts for the accounting period.
The formula is represented in the image below
Solvency ratio analysis
Solvency ratios have been designed to measure the overall profitability of a company or business by comparing profitability levels against current financial obligations. Calculating and analyzing these ratios can provide business owners, chief financial officers, investors, insurance companies, and banking institutions with valuable financial insights, particularly the company’s ability to meet its current long-term debt obligations.
Analyzing solvency ratios is important for small businesses just as it is important for large businesses. Calculating the ratio is only the first step, the analysis is equally important. Here, one will be able to examine ratio metrics and have a more complete picture for management, investors, creditors, and lenders to review.
- Long-term financial obligations
- Performance analysis
- Helps in investing
Long-term financial obligations
Through the solvency ratio, investors and analysts are able to measure the financial health of a company on the basis of its ability to fulfill its long-term financial obligations. This process measures the total value of assets against the total value of liabilities to present the amount of cash the company has to meet the financial obligation.
The cash flow of a company and the solvency factor is a direct metric that calculates a company’s business performance. Solvency ratios measure a company’s capacity to earn revenues to pay off debt. Analysts and investors widely use this metric to analyze the performance of the company. These investors compare historical solvency ratios with the present in order to get an idea of how the company is performing.
Helps in investing
Investors make use of solvency ratios to make informed investment decisions thereby cutting the risk of losses by a huge margin. If a company’s solvency ratio is high, then it implies that the company will effectively pay off its debt. This brings about a positive sentiment around investors and increases the share price.
Limitations of solvency ratio
- Irrational results
- New funding
- Extensive process
Solvency ratios only consider the debt of a company to measure solvency. It is possible for a company to have a low debt amount but yet head towards bankruptcy due to increasing accounts payable and bad cash management. Although the company is in bad financial health, the solvency ratio will not reveal it in its results.
The calculation of the solvency ratio does not factor in the capability of a company to acquire new funds through means such as stocks or funds. Hence, the solvency ratio may change over time, therefore, it should be used alongside other ratios to determine the fair solvency of the company.
There are different types of solvency ratios that investors can make use of in determining the solvency prospect of a company. However, the fact that multiple types exist will always result in complicating the process.Last Updated on November 6, 2023 by Nansel Nanzip Bongdap