A solvency ratio indicates whether a company’s cash flow is sufficient to meet its long-term liabilities and is therefore a measure of its financial health. An unfavorable ratio can indicate a probability that a company will default on its financing obligations.

Key aspects of solvency ratios

• A solvency ratio examines a company’s ability to meet its long-term debts and obligations.

• The main solvency ratios include the debt-to-assets ratio, the interest coverage ratio, the equity ratio, and the debt-to-equity ratio (D/E).

• Solvency ratios are often used by potential lenders when evaluating a company’s creditworthiness, as well as by investors.

• Solvency ratios and liquidity ratios both measure a company’s financial health, but solvency ratios take a longer-term view than liquidity ratios.

• Like other financial ratios, solvency ratios are usually more valuable when compared over time or against other companies.

Understanding Solvency Ratios

A solvency ratio is one of many metrics used to determine whether a company can remain solvent over the long term. It’s a comprehensive measure of solvency, as it measures a company’s actual cash flow — rather than net income — by adding back depreciation and other non-cash expenses to assess a company’s ability to stay afloat.

This ratio measures cash flow capacity relative to all obligations, rather than just short-term debt. In this way, a solvency ratio assesses a company’s long-term health by evaluating its ability to repay long-term debt and the interest on that debt.

Solvency ratios vary from industry to industry. Therefore, a company’s solvency ratio should be compared with that of its competitors in the same industry rather than viewed in isolation.

Types of Solvency Ratios

1.- Interest Coverage Ratio

The interest coverage ratio is calculated as follows:

I.C.R. = EBIT / Interest.Expenses

Where:

I.C.R. = Interest Coverage Ratio

EBIT = Earnings before interest and taxes

This ratio measures how many times a company can cover its current interest payments with its available earnings. In other words, it measures the margin of safety a company has to pay interest on its debt during a given period.

The higher the ratio, the better. If the ratio drops to 1.5 or less, it can indicate that a company will have difficulty meeting interest payments on its debt.

2.- Debt-to-Assets Ratio

The debt-to-assets ratio is calculated as follows:

Debt.to.Assets.Ratio = Debt / Assets

This ratio measures a company’s total debt relative to its total assets. It measures a company’s leverage and indicates how much of the company is financed by debt compared to assets, and therefore its ability to repay its debt with available assets. A higher ratio, especially above 1.0, indicates that a company is significantly financed by debt and may have difficulty meeting its obligations.

3.- Equity Ratio

The shareholders’ equity ratio is calculated as follows:

Equity.Ratio = Total.Equity / Total.Assets

The equity ratio, or equity-to-assets ratio, shows how much of a company is financed by the company’s equity rather than debt. The higher the number, the healthier the company. The lower the number, the more debt a company has compared to equity.

4.- Debt-to-Equity Ratio (D/E)

The Debt-to-Equity (D/E) ratio is calculated as follows:

Debt.to.Equity.Ratio = Outstanding.Debt / Equity

The D/E ratio is similar to the debt-to-assets ratio in that it indicates how a company is financed — in this case, by debt. The higher the ratio, the more debt a company has on its books, which means a higher probability of default. The ratio shows how much of the debt can be covered by the company’s equity if the company needed to be liquidated.

Solvency Ratios vs. Liquidity Ratios

Solvency ratios and liquidity ratios are similar but have some important differences. Both categories of financial ratios indicate a company’s health. The main difference is that solvency ratios offer a longer-term perspective on a company, while liquidity ratios focus on the short term.

Solvency ratios examine all of a company’s assets, including long-term debt such as bonds with maturities greater than one year. Liquidity ratios, on the other hand, focus on the most liquid assets, such as cash and marketable securities, and how these can be used to cover upcoming short-term obligations.

If an analyst wants to know whether a company will be able to pay its bills next year, they’re often more interested in looking at the company’s liquidity. If a company is illiquid, it won’t be able to pay its short-term bills as they come due. On the other hand, analysts more interested in a long-term assessment of a company will want to analyze the solvency ratios.

Limitations of Solvency Ratios

A company may have a low amount of debt, but if its cash management practices are poor and accounts receivable are increasing as a result, its solvency position may not be as solid as metrics that only consider debt would indicate.

It’s important to look at a variety of ratios to understand a company’s true financial health, as well as to understand the reason why a ratio is what it is. Also, a number on its own won’t give much indication. A company must be compared with its peers, particularly the 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 due to the nature of its business. An airline must buy planes, pay for hangar space, and buy jet fuel — costs that are significantly higher than what a tech company will face.

Conclusion on solvency ratios

Solvency ratios are financial measurements that generally look at a company’s total assets, total debt, or total equity to better understand the company’s financial structure. This financial structure plays a critical role in knowing whether the company will be able to pay its long-term debts as they come due and have enough money over the long term. The most common solvency ratios are the debt-to-equity ratio, the debt-to-assets ratio, and the interest coverage ratio.

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