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 thus is a measure of its financial health. An unfavorable ratio can indicate some likelihood that a company will default on its debt obligations.

Key Takeaways

  • A solvency ratio examines a firm'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 (D/E) ratio.
  • Solvency ratios are often used by prospective lenders when evaluating a company's creditworthiness as well as by potential bond investors.
  • Solvency ratios and liquidity ratios both measure a company's financial health but solvency ratios have a longer-term outlook than liquidity ratios.
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Solvency Ratio

Understanding Solvency Ratios

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

It measures this cash flow capacity versus all liabilities, rather than only short-term debt. This way, 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 vary from industry to industry. A company’s solvency ratio should, therefore, be compared with its competitors in the same industry rather than viewed in isolation.

A solvency ratio terminology is also used when evaluating insurance companies, comparing the size of their capital relative to the premiums written, and measures the risk an insurer faces on claims it cannot cover.

The main 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 may 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:

Interest Coverage Ratio = EBIT Interest Expenses \text{Interest Coverage Ratio}=\frac{\text{EBIT}}{\text{Interest Expenses}} Interest Coverage Ratio=Interest ExpensesEBIT

where:

  • EBIT = Earnings before interest and taxes

The interest coverage 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 for paying interest on its debt during a given period.

The higher the ratio, the better. If the ratio falls to 1.5 or below, it may 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:

Debt-to-Assets Ratio = Debt Assets \text{Debt-to-Assets Ratio}=\frac{\text{Debt}}{\text{Assets}} Debt-to-Assets Ratio=AssetsDebt

The debt-to-assets ratio measures a company's total debt to its total assets. It measures a company's leverage and indicates how much 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 significantly funded by debt and may have difficulty meetings its obligations.

Equity Ratio

The shareholder equity ratio is calculated as follows:

SER = TSE Total assets where: SER = Shareholder equity ratio TSE = Total shareholder equity \begin{aligned}&\text{SER}=\frac{\text{TSE}}{\text{Total assets}}\\\textbf{where:}\\&\text{SER}\!=\!\text{Shareholder equity ratio}\\&\text{TSE}\!=\!\text{Total shareholder equity}\end{aligned} where:SER=Total assetsTSESER=Shareholder equity ratioTSE=Total shareholder equity

The equity ratio, or equity-to-assets, shows how much 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:

Debt to Equity Ratio = Debt Outstanding Equity \text{Debt to Equity Ratio}=\frac{\text{Debt Outstanding}}{\text{Equity}} Debt to Equity Ratio=EquityDebt Outstanding

The D/E ratio is similar to 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 looks at how much of the debt can be covered by equity if the company needed to liquidate.

Solvency Ratios vs. Liquidity Ratios

Solvency ratios and liquidity ratios are similar but have some important differences. Both of these categories of financial ratios will indicate the health of a company. The main difference is that solvency ratios offer a longer-term outlook on a company whereas liquidity ratios focus on the shorter term.

Solvency ratios look at all assets of a company, including long-term debts such as bonds with maturities longer than a year. Liquidity ratios, on the other hand, look at just the most liquid assets, such as cash and marketable securities, and how those can be used to cover upcoming obligations in the near term.

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Liquidity Vs. Solvency

Limitations of Solvency Ratios

A company may have a low debt amount, but if its cash management practices are poor and accounts payable are surging as a result its solvency position may not be as solid as would be indicated by measures that include only debt.

It's important to look 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 much of an indication. A company needs to be compared to its peers, particularly the strong companies in its industry, to determine if 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 has to buy planes, pay for hangar space, and buy jet fuel; costs that are significantly more than a technology company will ever have to face.

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. 

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 popular metric that measures the degree that a company’s assets are financed by debt, where debt-to-assets equals total assets divided by total debt. 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—also referred to as leverage ratios—analyze the impact on long-term obligations, and a company’s ability to continue operating over a longer horizon. By contrast, liquidity ratios look at two main objectives: a company’s ability to pay for short-term liabilities due under a year and the ability to quickly sell assets to raise cash.