What Is a Solvency Ratio? (Types, Examples, and Guide)
By Indeed Editorial Team
Published May 13, 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Solvency is a critical metric for assessing a business's long-term financial health. Measuring different ratios of solvency often shows how efficiently companies can pay off debt and fund operations with assets. Evaluating each ratio of solvency is critical in developing cost-reducing strategies and process enhancements that support profitable outcomes. In this article, we define the solvency ratio, discuss its importance, review the different types, provide steps to calculate solvency ratios, explore the difference between ratios of solvency and liquidity ratios, and examine examples.
What is a solvency ratio?
A solvency ratio is a financial statistic that shows a company's ability to cover long-term liabilities and their efficiency of generating cash to meet long-term debt obligations. Ratios of solvency often provide insight into a business's financial health and enable investors, managers, and shareholders to make more informed decisions about its profitability. It typically considers the actual cash flow and all forms of a company's financial obligations, not only its short-term obligations.
While a company's debt may be modest, if its cash management techniques are ineffective and accounts payable are high as a result, its solvency situation may not be as good as shown by debt-only measurements. You can compare a company to its counterparts, particularly the most substantial companies in its field, to assess whether a company's ratio is acceptable.
Importance of measuring solvency
Solvency is critical for financial measurements and performance analysis, as it enables experts to:
Project future cash flows: Determining a company's ratios of solvency is critical to understanding the impact of business operations and financial activities on cash flow. Companies can better predict long-term cash flow with ratio analysis data.
Monitor long-term liabilities: Companies can also use ratios of solvency to successfully monitor how cash flow supports long-term loans. Solvency calculations can aid in the development of more efficient techniques for tracking debt and interest.
Establish budgets: Setting budgets is also a factor in determining a company's financial stability. You can better allocate revenue and reduce expenditures if you use data from solvency calculations.
Evaluate financial risk: You can evaluate a company's long-term profitability and growth prospects by looking at a company's solvency. Investors can better understand a company's financial health by looking at how efficiently it distributes cash flow to fund long-term liabilities.
Types of ratios of solvency
Here's a list of some types of ratios of solvency that businesses usually employ to determine their financial health:
Interest coverage ratio
This ratio measures how much money you've set aside each month to cover the interest you've accrued on your debt. An interest coverage ratio of over 1.5 shows that a company can protect its interest obligations. To calculate the interest coverage ratio, divide the earnings before interest and taxes (EBIT) value by the total interest expense.
The debt-to-asset ratio measures how much a company owes compared to what it owns and shows its financial health. If the debt-to-asset ratio exceeds one, it suggests that a company depends more on borrowed money than resources to fund its operations. In contrast, when a company is relying more on its resources, the ratio is less than one. To calculate the debt-to-asset ratio, divide a company's total debt by its total asset value.
Comparing equity against assets shows how much equity a company uses to fund its operations instead of debt. The higher a company's equity ratio, the more likely it is to achieve its goals using equity rather than debt. You can calculate a company's equity ratio by dividing its shareholders' equity by its total assets.
The debt-to-equity ratio shows how much debt a business uses to finance its operations compared to its equity. When a company uses debt to fund continuing operations, it's vital to monitor equity to ensure that it's substantial enough to settle debts in the event of a liquidation. You can divide all existing loans by the total amount of equity to determine the debt-to-equity ratio.
How to calculate ratios of solvency
Here's a list of steps you can follow to calculate different ratios of solvency:
1. Determine the metric you're measuring
Determine the ratio of solvency you wish to measure by determining which business operations require evaluation. For example, a business can use the ratio of solvency to compare its total debts to its total assets. Cash flow, assets and stock can provide capital growth, while liabilities and expenses deplete the company's available funds.
2. Gather necessary financial data
Gather the financial information required to compute any of your ratios of solvency. For example, data on current and long-term debt and total shareholder equity can determine a company's ability to cover its operations with equity rather than debt. Ensure you collect essential financial data to enhance accuracy.
3. Apply the appropriate formula
You can evaluate measures using a variety of solvency formulas, so it's important to identify the appropriate one for your task. After calculating the correct ratio formula, you can study the data and collaborate with other team members to identify cost-reducing and cash-flow-increasing strategies. Applying a suitable formula can aid in continuing business activities, as it usually helps manage costs.
Ratios of solvency vs. liquidity ratios
You can closely relate liquidity ratios and ratios of solvency, as both are tools investors use to make investment decisions, as they indicate a company's financial health. The main difference between the two is while ratios of solvency provide a company's longer-term outlook, liquidity ratios focus on its immediate future. Ratios of solvency look at the company's total assets, including long-term debts like bonds that have a maturity of more than a year. In contrast, liquidity ratios only look at the most liquid assets, such as cash and marketable securities, which can cover upcoming obligations within a short period.
Examples of ratios of solvency
Here's a list of examples that can help you gain a better understanding of how to use these ratios:
Interest coverage ratio example
Here's an example of interest coverage ratio:
David Wharton Corporation measures its solvency to evaluate its ability to take on additional debt to purchase a new facility. For this reason, before applying for funding, it wants to make sure that it has enough cash to cover its current interest obligations. After subtracting the company's current interest costs, financial analysts can determine if they can pay off the new debt. Analysts have calculated an estimated $7,500,000 in EBIT and $4,200,000 in current interest obligations. Here's the calculation for the interest ratio:
Interest ratio = EBIT / current interest
$7,500,000 / $4,200,000 = 1.79
Debt-to-asset ratio example
Here's an example of debt-to-asset ratio:
Management at Theta Bionics uses the debt-to-asset calculation to assess the company's solvency and determine the total amount of debt required to fund operations. There are long-term and short-term debt obligations that the accountant can consider. They determine all the company's current and long-term financial assets, including inventory, cash on hand, revenue, and investment returns. The company has $645,000 in debt and $625,000 in assets. Here's the calculation of the debt-to-asset ratio:
Debt-to-asset = total debt / total assets
$645,000 / $625,000 = 1.03
Equity ratio example
Here's an example of calculating an equity ratio:
Trivega Industries has equity as stockholders' stock, real estate holdings, and investment returns. Financial analysts want to know how much of the company's growth can attribute to equity and assets rather than additional debt as the company continues to expand. Financial analysts use the equity ratio to estimate its shareholder equity at $9,000,000 and its total assets at $6,000,000. With this formula, analysts can calculate the equity ratio:
Equity ratio = total shareholder equity / total assets
$9,000,000 / $6,000,000 = 1.5
Debt-to-equity ratio example
Here's an example of calculating the debt-to-equity ratio:
Financial analysts are interested in measuring how much debt Highlands Automotive uses for production costs. Investors and financial planners want to better assess Highlands Automotive's long-term profitability and viability by knowing how much debt it has taken to fund its short- and long-term liabilities. Investors want to know how debt covers the company's operating expenses, even though it uses some of its equity to do so. To calculate a company's debt-to-equity ratio, divide its total debt by its total equity, including shareholder equity. If Highlands Automotive's debt is worth $2,500,000, while its equity is worth $8,000,000, here how to calculate the ratio of debt to equity:
Debt-to-equity = total debt / total equity
$2,500,000 / $8,000,000 = 0.31
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