What is a solvency ratio?
A solvency ratio is a key metric used to measure a company’s ability to meet its long-term obligations and is often used by potential commercial lenders. A solvency ratio indicates whether a company’s cash flow is sufficient to meet its long-term commitments and therefore is a measure of its financial health. An unfavorable ratio may indicate a certain probability that a company will default on its debt obligations.
The main solvency ratios are the debt ratio, the interest coverage ratio, the equity ratio and the debt ratio. These measures can be compared to liquidity ratios, which take into account a company’s ability to meet short-term obligations rather than medium to long-term obligations.
Key points to remember
- A solvency ratio examines a company’s ability to honor its long-term debts and obligations.
- The main solvency ratios include the leverage ratio, the interest coverage ratio, the equity ratio and the debt ratio.
- Credit ratios are often used by potential lenders to assess a company’s creditworthiness as well as by potential bond investors.
- Both solvency ratios and liquidity ratios measure the financial health of a business, but solvency ratios have a longer-term perspective than liquidity ratios.
Understanding solvency ratios
A solvency ratio is one of the many measures used to determine whether a business can remain solvent over the long term.
A solvency ratio is a comprehensive measure of solvency because it measures a company’s actual cash flow, rather than net income, adding depreciation and other non-cash expenses to assess a company’s capacity. to stay afloat.
It measures this cash capacity against all liabilities, rather than short-term debt alone. In this way, a solvency ratio assesses the long-term health of a business by assessing its ability to repay its long-term debt and the interest on that debt.
Solvency ratios vary from industry to industry. A company’s solvency ratio should therefore be compared to its competitors in the same industry rather than viewed in isolation.
A terminology relating to the solvency ratio is also used with regard to insurance companies, comparing the size of its capital in relation to the premiums written, and measuring the risk to which the insurer is confronted on claims that it cannot. cover.
Types of solvency ratios
Interest coverage ratio
The interest coverage ratio is calculated as follows:
The interest coverage ratio measures a company’s ability to pay interest on its debt with its profits. Specifically, it measures how many times a business can repay its interest with its current profits, as such it includes a safety margin.
The higher the ratio, the better. If the ratio drops to 1.5 or less, it may indicate that a business will have difficulty meeting interest on its debts.
Debt to assets ratio
The debt ratio is calculated as follows:
The debt-to-asset ratio measures a company’s total debt compared to its total assets. It measures a company’s indebtedness and indicates how well the company is funded by debt compared to assets, and therefore, its ability to repay debt with available assets.
A higher ratio, especially above 1.0, indicates that a business is significantly funded by debt and may have difficulty meeting its obligations.
The equity ratio is calculated as follows:
The equity ratio, or equity to assets, shows how well a business is funded by equity as opposed to debt. The higher the number, the healthier the business. The lower the number, the higher a company’s debt relative to equity.
Debt / equity ratio
The debt / equity ratio (D / E) is calculated as follows:
The debt ratio is similar to the debt ratio, in that it indicates how a business is financed, in this case by debt. The higher the ratio, the more debt a business has on its books, which means the probability of default is higher. The ratio examines how much of the debt can be covered by equity if the company is to liquidate.
Limitations of solvency ratios
A business may have a low amount of debt, but if its cash management practices are poor and accounts payable increase as a result, its solvency position may not be as strong as indicated by metrics that only include debt.
It’s important to look at a variety of ratios to understand the true financial health of a business, as well as to understand why a ratio is what it is. Also, a number itself will not give much indication. A company should be benchmarked against its peers, especially strong companies in its industry, to determine whether the ratio is acceptable or not.
For example, an airline will have more debt than a tech company just because of the nature of its business. An airline has to buy planes, pay for hangar space, and buy kerosene; costs far greater than those a tech company will ever face.
Solvency ratios to liquidity ratios
The solvency ratios and the liquidity ratios are similar but have important differences. These two categories of financial ratios will provide an indication of the health of a business. The main difference is that solvency ratios are a longer-term outlook for a business, while liquidity ratios are a shorter-term outlook.
Solvency ratios cover all of a company’s assets, including long-term debts such as bonds with maturities greater than one year; while liquidity ratios relate only to the most liquid assets, such as cash and marketable securities, and how these can be used to hedge short-term future obligations.