Solvency Ratio
What Is a Solvency Ratio?
A solvency ratio is a key metric used to measure an enterprise's ability to meet its long-term debt obligations and is used often by prospective business lenders. A solvency ratio indicates whether a company's cash flow is sufficient to meet its long-term liabilities and hence is a measure of its financial health. An unfavorable ratio can indicate some likelihood that a company will default on its debt obligations.
Understanding Solvency Ratios
A solvency ratio is one of numerous metrics used to determine whether a company can remain solvent in the long term. A solvency ratio is a comprehensive measure of solvency, as it measures a firm's real cash flow, rather than net income, by adding back depreciation and other non-cash expenses to assess a company's capacity to remain above water.
It measures this cash flow capacity versus all liabilities, rather than just short-term debt. Along these lines, a solvency ratio assesses a company's long-term health by evaluating its repayment ability for its long-term debt and the interest on that debt.
Solvency ratios fluctuate from one industry to another. A company's solvency ratio should, therefore, be compared with its competitors in the same industry rather than viewed in disengagement.
A solvency ratio terminology is likewise used when evaluating insurance companies, looking at the size of their capital relative to the premiums written, and measures the risk an insurer faces on claims it can't cover.
The principal solvency ratios are the debt-to-assets ratio, the interest coverage ratio, the equity ratio, and the debt-to-equity (D/E) ratio. These measures might be compared with liquidity ratios, which consider a firm's ability to meet short-term obligations rather than medium-to long-term ones.
Types of Solvency Ratios
Interest Coverage Ratio
The interest coverage ratio is calculated as follows:
where:
- EBIT = Earnings before interest and taxes
The interest coverage ratio measures how frequently a company can cover its current interest payments with its available earnings. In other words, it measures the margin of safety a company has for paying interest on its debt during a given period.
The higher the ratio, the better. Assuming that the ratio tumbles to 1.5 or below, it might indicate that a company will have difficulty meeting the interest on its debts.
Debt-to-Assets Ratio
The debt-to-assets ratio is calculated as follows:
The debt-to-assets ratio measures a company's total debt to its total assets. It measures a company's leverage and indicates the amount of the company is funded by debt versus assets, and therefore, its ability to pay off its debt with its available assets. A higher ratio, especially above 1.0, indicates that a company is fundamentally funded by debt and may have difficulty meetings its obligations.
Equity Ratio
The shareholder equity ratio is calculated as follows:
The equity ratio, or equity-to-assets, shows the amount of a company is funded by equity as opposed to debt. The higher the number, the healthier a company is. The lower the number, the more debt a company has on its books relative to equity.
Debt-to-Equity (D/E) Ratio
The debt-to-equity (D/E) ratio is calculated as follows:
The D/E ratio is like the debt-to-assets ratio, in that it indicates how a company is funded, in this case, by debt. The higher the ratio, the more debt a company has on its books, meaning the likelihood of default is higher. The ratio takes a gander at the amount of the debt can be covered by equity in the event that the company needed to liquidate.
Solvency Ratios versus Liquidity Ratios
Solvency ratios and liquidity ratios are comparative however have some important differences. Both of these categories of financial ratios will indicate the health of a company. The fundamental difference is that solvency ratios offer a longer-term outlook on a company whereas liquidity ratios center around the shorter term.
Solvency ratios check out at all assets of a company, including long-term debts like bonds with maturities longer than a year. Liquidity ratios, then again, take a gander at just the most liquid assets, like cash and marketable securities, and how those can be used to cover impending obligations in the near term.
Limitations of Solvency Ratios
A company might have a low debt amount, however assuming its cash management practices are poor and accounts payable are flooding as a result its solvency position may not be basically as solid as would be indicated by measures that include just debt.
It's important to take a gander at a variety of ratios to comprehend the true financial health of a company, as well as understand the reason that a ratio is what it is. Furthermore, a number itself won't give quite a bit of an indication. A company needs to be compared to its peers, especially the strong companies in its industry, to determine on the off chance that the ratio is an acceptable one or not.
For example, an airline company will have more debt than a technology firm just by the nature of its business. An airline company needs to buy planes, pay for shed space, and buy jet fuel; costs that are essentially more than a technology company will ever have to face.
Features
- The principal solvency ratios include the debt-to-assets ratio, the interest coverage ratio, the equity ratio, and the debt-to-equity (D/E) ratio.
- Solvency ratios and liquidity ratios both measure a company's financial health however solvency ratios have a longer-term outlook than liquidity ratios.
- A solvency ratio examines a firm's ability to meet its long-term debts and obligations.
- Solvency ratios are often used by prospective lenders when evaluating a company's creditworthiness as well as by potential bond investors.
FAQ
How Is a Solvency Ratio Calculated?
Solvency ratios measure a company's cash flow, which includes non-cash expenses and depreciation, against all debt obligations. For instance, consider the debt-to-assets ratio, a famous metric that measures the degree that a company's assets are financed by debt, where debt-to-assets equals total debt divided by total assets. Another common solvency ratio, the debt-to-equity (D/E) ratio, shows how financially leveraged a company is, where debt-to-equity equals total debt divided by total equity.
What Is the Difference Between a Solvency Ratio and a Liquidity Ratio?
Solvency ratios — likewise referred to as leverage ratios — analyze the impact on long-term obligations, and a company's ability to continue operating over a longer horizon. Paradoxically, liquidity ratios check two principal objectives: a company's ability to pay for short-term liabilities due under a year and the ability to rapidly sell assets to raise cash out.
What Are Solvency Ratios?
A solvency ratio measures how well a company's cash flow can cover its long-term debt. Solvency ratios are a key metric for assessing the financial health of a company and can be used to determine the likelihood that a company will default on its debt. Solvency ratios differ from liquidity ratios, which analyze a company's ability to meet its short-term obligations.
