Solvency Ratio

AAA

DEFINITION of 'Solvency Ratio'

A key metric used to measure an enterprise’s ability to meet its debt and other obligations. The solvency ratio indicates whether a company’s cash flow is sufficient to meet its short-term and long-term liabilities. The lower a company's solvency ratio, the greater the probability that it will default on its debt obligations.

The measure is usually calculated as follows:

INVESTOPEDIA EXPLAINS 'Solvency Ratio'

Solvency ratio, with regard to an insurance company, means the size of its capital relative to the premiums written, and measures the risk an insurer faces of claims it cannot cover.

The solvency ratio is only one of the metrics used to determine whether a company can stay solvent. Other solvency ratios include debt to equity, total debt to total assets, and interest coverage ratios.

However, the solvency ratio is a comprehensive measure of solvency, as it measures cash flow – rather than net income – by including depreciation to assess a company’s capacity to stay afloat. It measures this cash flow capacity in relation to all liabilities, rather than only debt. Apart from debt and borrowings, other liabilities include short-term ones such as accounts payable and long-term ones such as capital lease and pension plan obligations.

Measuring cash flow rather than net income is a better determinant of solvency, especially for companies that incur large amounts of depreciation for their assets but have low levels of actual profitability. Similarly, assessing a company’s ability to meet all its obligations – rather than debt alone – provides a more accurate picture of solvency. A company may have a low debt amount, but if its cash management practices are poor and accounts payable is surging as a result, its solvency position may not be as solid as would be indicated by measures that include only debt.

A company’s solvency ratio should also be compared with its competitors in the same industry rather than viewed in isolation. For example, companies in debt-heavy industries like utilities and pipelines may have lower solvency ratios than those in sectors such as technology. To make an apples-to-apples comparison, the solvency ratio should be compared for all utility companies, for example, to get a true picture of relative solvency.

VIDEO

Loading the player...
RELATED TERMS
  1. Statutory Reserves

    State regulated reserve requirements. Insurance companies must ...
  2. Bridge Bank

    A bank authorized to hold the assets and liabilities of another ...
  3. Economic Capital

    The amount of capital that a firm, usually in financial services, ...
  4. Default Risk

    The event in which companies or individuals will be unable to ...
  5. Fundamental Analysis

    A method of evaluating a security that entails attempting to ...
  6. Credit Enhancement

    A method whereby a company attempts to improve its debt or credit ...
RELATED FAQS
  1. What is the difference between the capital adequacy ratio vs. the solvency ratio?

    Both the capital adequacy ratio and the solvency ratio provide ways to evaluate a company's debt versus its revenues situation. ... Read Full Answer >>
  2. What are the differences between solvency ratios and liquidity ratios?

    Liquidity ratios and solvency ratios are tools investors use to make investment decisions. Liquidity ratios measure a company's ... Read Full Answer >>
  3. Are solvency ratios more concerned with the short-term or the long-term?

    Solvency is a company's ability to meet all of its debt obligations. Solvency generally describes a company's ability to ... Read Full Answer >>
  4. How are liquidity ratios different than solvency ratios?

    Liquidity ratios measure a company's ability to meet short-term debt obligations, while solvency ratios measure a company's ... Read Full Answer >>
Related Articles
  1. Personal Finance

    Texas Ratio Rounds Up Bank Failures

    This measure can help investors spot potential trouble in a bank's financials. Find out how.
  2. Fundamental Analysis

    Ratio Analysis Tutorial

    If you don't know how to evaluate a company's present performance and its possible future performance, you need to learn how to analyze ratios.
  3. Investing Basics

    Analyze Investments Quickly With Ratios

    Make informed decisions about your investments with these easy equations.
  4. Fundamental Analysis

    Analyzing Investments With Solvency Ratios

    Solvency ratios are extremely useful in helping analyze a firm’s ability to meet its long-term obligations; but like most financial ratios, they must be used in the context of an overall company ...
  5. Fundamental Analysis

    Financial Analysis: Solvency Vs. Liquidity Ratios

    Solvency and liquidity are equally important for a company's financial health. A number of financial ratios are used to measure a company’s liquidity and solvency, and an investor should use ...
  6. Options & Futures

    Understanding Financial Liquidity

    Understanding how this measure works in the market can help keep your finances afloat.
  7. Trading Strategies

    Introduction to Types of Trading: Fundamental Traders

    Learn about the different traders and explore in detail the broader approach that focuses on company-specific events.
  8. Bonds & Fixed Income

    An Overview Of Corporate Bankruptcy

    If a company files for bankruptcy, stockholders have the most to lose. Find out why.
  9. Markets

    Introduction To Fundamental Analysis

    Learn this easy-to-understand technique of analyzing a company's financial statements and reports.
  10. Fundamental Analysis

    The Future of Big Pharma Stocks

    A look at the future health of big pharma stocks.

You May Also Like

Hot Definitions
  1. Loan-To-Value Ratio - LTV Ratio

    A lending risk assessment ratio that financial institutions and others lenders examine before approving a mortgage.
  2. DuPont Analysis

    A method of performance measurement that was started by the DuPont Corporation in the 1920s. With this method, assets are ...
  3. Asset Class

    A group of securities that exhibit similar characteristics, behave similarly in the marketplace, and are subject to the same ...
  4. Fiat Money

    Currency that a government has declared to be legal tender, but is not backed by a physical commodity. The value of fiat ...
  5. Interest Rate Risk

    The risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between ...
  6. Income Effect

    In the context of economic theory, the income effect is the change in an individual's or economy's income and how that change ...
Trading Center