It is very common for businesses to take out loans to meet their business expenses, gather funds for expansion, and maintain their operational costs. While some debts may be short-term in nature, some are long-term loans that are paid along with interest. A company’s ability to meet long-term debt obligations can be assessed with a metric known as the solvency ratio.
This blog explores the importance of solvency ratio, its types, and how it is different from liquidity ratio. Read on to know more!
In corporate finance, a solvency ratio is a metric used to determine a company’s capacity to fulfil its long-term debt obligations. Potential business lenders often use solvency ratios to determine a company’s capacity to pay back its long-term debts.
A company’s financial health can also be assessed by its solvency ratio. An unfavourable ratio might suggest a high likelihood that the company will fail to pay its long-term debts. However, it is important to note that liquidity ratios, which assess a company’s capacity to repay short-term debts, are different from solvency ratios (more on this below).
There are several different kinds of solvency ratios, but the most generic solvency ratio formula is as follows:
Solvency Ratio = (Net Income + Depreciation) / All Liabilities (Short-term + Long-term Liabilities)
The formula above represents a company’s current cash flow, while the denominator represents its liabilities. Thus, solvency ratio indicates whether the company’s cash flow is adequate to pay its total liabilities.
Let’s take a look at an example where we calculate a company’s solvency ratio and get some insight into its financial health. Consider a company with the following financials:
|Particulars||Amount (in Rs.)|
Then, if we use these numbers into the formula given above, we get:
Solvency ratio = (15,000 + 3,000) / (32,000 + 60,000) = 19.6%.
It is important to note that a company is considered financially strong if its solvency ratio exceeds 20%. So, from the above solvency ratio example, the company is falling just short of being considered financially healthy.
Also Read: What is Treynor Ratio, How is It Calculated and Why Do Traders Use It?
The solvency ratio of a business should be checked regularly to ensure its financial stability. Solvency ratios may help business owners determine whether they need to redistribute internal and external equities and may also help them assess their business’s capital structure.
Solvency ratios are an important consideration for companies seeking additional debt. Therefore, calculating a company’s solvency ratio aids crucial financial decision-making and can increase the odds of future profitability. Additionally, the solvency ratio also serves to reassure investors and creditors that the company can pay off its debts in the long run.
Ideal solvency ratio values may differ for different industries. For instance, technology firms typically have higher ideal solvency ratios than utility firms. Also, some companies can manage their debts despite having lower-than-ideal solvency ratios.
There are four main types of solvency ratios, as discussed below:
This ratio assesses a company’s capacity to cover its interest payments, which rises alongside its total debt. By dividing earnings before interest and tax (EBIT) by interest expenses, you can determine the interest coverage ratio for a company.
So, the formula of Interest Coverage Ratio is:
Interest Coverage Ratio = Earnings before Interest and Taxes / Interest Expenses
Businesses with interest coverage ratios of 1.5 or less may have trouble getting loans from banks and other lenders. Businesses can reduce their debt or grow their overall profits to improve their interest coverage ratio.
Also known as the gearing ratio, debt-to-equity ratio helps measure a company’s total debt to the amount invested by the owners of the company ( or its equity). Companies generally prefer to keep their debt-to-equity ratios low since it implies that the company has less debt on its balance sheet against the outstanding shares.
The formula for debt-to-equity ratio is as follows:
Debt-to-equity Ratio = Total Outstanding Debt / Total Equity
Debt-to-asset ratio indicates the debt a business has in comparison to its total assets. A debt-to-asset ratio of more than 1.0 indicates that a business is heavily dependent on debt funding and might struggle to pay its debts.
The formula for debt-to-asset ratio is as follows:
Debt-to-asset ratio = Debt / Assets
The equity ratio or equity-to-assets ratio indicates the extent to which a company is funded through equity rather than debt.
Most companies aim for a high equity ratio because it demonstrates that not much debt is being used to finance it. A low equity ratio does not bode well for a company’s solvency.
The formula is:
Equity Ratio = Total Shareholder Equity / Total Assets
Here’s a list of advantages and disadvantages of solvency ratio:
|Performance measurement: Solvency ratios, which analysts and investors frequently use to evaluate company performance, quantify a company’s ability to pay off debt. To that end, these investors compare historical solvency ratios with the current ratio.||May not give complete picture: Solvency ratios take into consideration the company’s debt. However, despite a low amount of debt, a business may be on the verge of bankruptcy because of rising account payables and poor cash management. In such a case, even though the company’s financial situation is poor, the solvency ratio will not reflect it.|
|Informed decision-making: Solvency ratios are used by investors to make informed investment decisions because they significantly reduce the risk of losses. A company’s solvency ratio indicates how effectively it will pay off its debt, which encourages confidence among investors.||New funding: The ability of a company to raise new funds through sources like stock or funds is not taken into account when determining the solvency ratio. The solvency ratio should, therefore, be used in combination with other ratios to assess the company’s solvency because it may change over time.|
Liquidity ratios measure the ability of a company to use its liquid assets to pay off short-term debts. The solvency ratio, on the other hand, assesses a company’s capacity to pay off its debts over the long term. Investors often use both solvency and liquidity ratios as important parameters when making investment decisions.
Also Read: What is Financial Ratio Analysis? – Know the Types, Advantages and Disadvantages
Solvency ratios measure a company’s ability to meet its long-term debt obligations. Doing so helps stakeholders better understand a company’s financial standing and make better informed decisions. It is important to understand that these ratios have their own limitations. They should be studied holistically, considering several other important factors and parameters.
Ans. The solvency ratio is a measure of a company’s ability to fulfil its long-term debt obligations.
Ans. The various types of solvency ratios are:
1. Interest coverage ratio
2. Debt-to-equity ratio
3. Debt-to-assets ratio
4. Equity ratio
Ans. A low solvency ratio may indicate that your business won’t be able to fulfil its debt obligations in the long run, which may reduce investor interest in your company, or the willingness of lenders to provide loans to your company.
Ans. Liquidity refers to an enterprise’s ability to pay short-term bills and debts, sell assets and quickly raise cash. Solvency, on the contrary, refers to a company’s ability to meet long-term debts and obligations.
Ans. Solvency ratios will usually differ from industry to industry, but generally, a solvency ratio of higher than 20% is considered to be an indicator of financial stability.
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