A company’s long-term financial health depends on multiple factors, some of which cannot be measured or predicted. However, there is a great deal of financial information available that can help you assess a company’s solvency. Solvency ratios express the likelihood that a company will be able to generate enough cash to pay off financial obligations, particularly long-term debt, and the corresponding interest.
In this article, you will learn about solvency ratios and their use in solvency analysis. You will also learn the formulas used to calculate the most frequently used ratios and how to interpret their values. To learn more about liquidity ratios, which focus on short-term debt and assets that can be converted to cash quickly, take a look at Liquidity Ratio: Types, Calculation & Examples.
What is a Solvency Ratio?
Solvency ratios express a company’s long-term financial health by assessing its ability to pay back current and long-term obligations, as well as the corresponding interest. The specific ratios used vary depending on the industry, as there are different accounting practices and benchmarks to consider.
Solvency analysis aims to establish the likelihood that a company will remain solvent, and it uses multiple metrics for this purpose, including solvency, liquidity, and profitability ratios.
Popular solvency ratios include the interest coverage ratio and the debt-to-equity ratio. However, there is no single ratio that can be used to determine a company’s solvency. As always, context is extremely important in solvency analysis. In addition to using multiple metrics, you should get industry benchmarks and compare your values to those of similar companies.
What is the Difference Between Liquidity and Solvency Ratios?
Liquidity and solvency ratios are often used to evaluate a company’s financial health. While both express a company’s ability to pay back debt, they focus on different types of assets and liabilities. While liquidity ratios focus on short-term debt, solvency ratios are concerned with financial obligations and long-term survival.
Why are Solvency Ratios Important?
Solvency ratios indicate the company‘s ability to generate enough cash to pay off short-term and long-term debt. This makes it especially important to long-term investors. The solvency ratio can help identify companies that are currently undervalued but are likely to increase in value in the future.
Types of Solvency Ratios
As mentioned above, multiple ratios and metrics are used to determine a company’s solvency. However, the following are the most frequently used in solvency analysis:
- Debt-to-Assets Ratio: It is used in many financial analyses, including leverage analysis. It expresses the proportion of current assets that are financed with both short- and long-term debt.
- Debt-to-Equity Ratio: Also used in other financial analyses. It shows the company’s outstanding debt in relation to its total shareholder equity.
- Interest Coverage Ratio: It expresses the company’s ability to pay the interest on any current debt using earnings before interest and taxes (EBIT).
Liquidity Ratio: Types, Calculation & Examples
Liquidity ratios are used to measure a company's ability to meet its long-term obligations. Here’s everything you need to know about Liquidity Ratios.
READ MORE
How to Calculate Solvency Ratios?
To calculate the solvency ratios described in the previous section, use the formulas shown below. The company’s balance sheet has the values you need to calculate these ratios.
- debt to assets ratio = total debt / total assets
- debt to equity ratio = total debt / total shareholder equity
- interest coverage ratio = EBIT* / interest expense
* EBIT = earnings before interest and taxes.
Solvency Ratio Examples
Company A’s financial statements contain the following information:
Using this information, you can easily calculate the following solvency ratios.
- 1. Debt to assets ratio: total debt / total assets.
- 2. Debt to equity ratio: total debt / total shareholder equity.
- 3. Interest coverage ratio: EBIT / interest expense.
- 4. That’s it. You have the results for all three ratios.
Solvency Ratio Interpretation
When interpreting the values for solvency ratios, it’s important to consider the context. You need to get industry benchmarks, as accounting practices vary between industries, and there are different expectations regarding acceptable amounts of debt. You also need to compare with companies that are similar to yours in terms of size and scope.
There are multiple ratios used to assess solvency, each with its own range of acceptable values. Additionally, remember that this range can vary depending on the industry and the size of the company. In the following section, you have generally accepted guidelines for the three solvency ratios mentioned in the previous section.
Leverage Ratio: Definition And How To Calculate
A leverage ratio provides you with information on how much a company depends on borrowed capital. Here’s what leverage ratios are and how to calculate them.
READ MORE
What is a Good Solvency Ratio?
Regarding the debt-to-assets ratio, the higher the value, the more leverage the company is using, which also means more risk for investors. Lower debt-to-assets ratios indicate more financial stability.
The debt-to-equity ratio compares the amount of outstanding debt to the amount of equity built up. The higher the ratio, the more the company is funded by debt. This is usually worrying to investors since it indicates the company may not be able to generate enough cash to pay off the interest on the debt. The next ratio is helpful in determining this.
The interest coverage ratio expresses a company’s ability to pay off the interest on outstanding debt. Therefore, higher values are usually better, as they show the company’s ability to pay off interest with plenty left over. Low values could indicate a higher likelihood that the company may be unable to cover loan payments.
Solvency Ratio Advantages & Disadvantages
One advantage of solvency ratios is that they provide more than just a snapshot of the company’s finances. Unlike liquidity ratios, solvency ratios focus on the company’s long-term financial health. The terms liquidity and solvency are often confused but actually express different concepts. Liquidity refers to a company’s ability to raise cash when it needs to, while solvency refers to its ability to meet long-term obligations.
As with any indicators, it’s possible for values to be misleading, particularly if they are interpreted individually. For your solvency analysis to be useful, you’ll need to incorporate other metrics, like liquidity, leverage, and profitability ratios.
Additionally, it’s very important to obtain industry benchmarks and comparison values for businesses similar to yours. This takes time and effort, but you can automate repetitive tasks using tools like Google Sheets and Layer. Schedule flows to update calculations, set up templates for financial analysis and assign tasks, and automatically share results with others.
Conclusion
As you have seen, solvency ratios can help you assess a business’ long-term financial health. Unlike liquidity ratios, which focus on turning assets into cash to pay off short-term debt, solvency ratios aim to represent the business’ ability to generate enough cash to pay off all of its liabilities, including interest due.
You now know about solvency ratios and the most frequently used ones. You also know how to calculate the most popularly used solvency ratios and how to interpret their values. To learn more about related financial ratios and analyses, take a look at these articles: