Solvency ratios are primarily used to measure a company's ability to meet its long-term obligations. In general, a solvency ratio measures the size of a company's profitability and compares it to its obligations. By interpreting a solvency ratio, an analyst or investor can gain insight into how likely a company will be to continue meeting its debt obligations. A stronger or higher ratio indicates financial strength. In stark contrast, a lower ratio, or one on the weak side, could indicate financial struggles in the future.
A primary solvency ratio is usually calculated as follows and measures a firm's cash-based profitability as a percentage of its total long-term obligations:
After Tax Net Profit + Depreciation
Commonly Used Solvency Ratios
Solvency ratios indicate a company's financial health in the context of its debt obligations. As you might imagine, there are a number of different ways to measure financial health.
Debt to equity is a fundamental indicator of the amount of leverage a firm is using. Debt generally refers to long-term debt, though cash not needed to run a firm’s operations could be netted out of total long-term debt to give a net debt figure. Equity refers to shareholders’ equity, or book value, which can be found on the balance sheet. Book value is a historical figure that would ideally be written up (or down) to its fair market value. But using what the company reports presents a quick and readily available figure to use for measurement.
Debt to assets is a closely related measure that also helps an analyst or investor measure leverage on the balance sheet. Since assets minus liabilities equals book value, using two or three of these items will provide a great level of insight into financial health.
More complicated solvency ratios include times interest earned, which is used to measure a company's ability to meet its debt obligations. It is calculated by taking a company's earnings before interest and taxes (EBIT) and dividing it by the total interest expense from long-term debt. It specifically measures how many times a company can cover its interest charges on a pretax basis. Interest coverage is another more general term used for this ratio.
Solvency Versus Liquidity Ratios
The solvency ratio measures a company's ability to meet its long-term obligations as the formula above indicates. Liquidity ratios measure short-term financial health. The current ratio and quick ratio measure a company's ability to cover short-term liabilities with liquid (maturities of a year or less) assets. These include cash and cash equivalents, marketable securities and accounts receivable. The short-term debt figures include payables or inventories that need to be paid for. Basically, solvency ratios look at long-term debt obligations while liquidity ratios look at working capital items on a firm’s balance sheet. In liquidity ratios, assets are part of the numerator and liabilities are in the denominator.
What Do These Ratios Tell an Investor?
Solvency ratios are different for different firms in different industries. For instance, food and beverage firms, as well as other consumer staples, can generally sustain higher debt loads given their profit levels are less susceptible to economic fluctuations. In stark contrast, cyclical firms must be more conservative because a recession can hamper their profitability and leave less cushion to cover debt repayments and related interest expenses during a downturn. Financial firms are subject to varying state and national regulations that stipulate solvency ratios. Falling below certain thresholds could bring the wrath of regulators and untimely requests to raise capital and shore up low ratios.
Acceptable solvency ratios vary from industry to industry, but as a general rule of thumb, a solvency ratio of greater than 20% is considered financially healthy. The lower a company's solvency ratio, the greater the probability that the company will default on its debt obligations. Looking at some of the ratios mentioned above, a debt-to-assets ratio above 50% could be cause for concern. A debt-to-equity ratio above 66% is cause for further investigation, especially for a firm that operates in a cyclical industry. A lower ratio is better when debt is in the numerator, and a higher ratio is better when assets are part of the numerator. Overall, a higher level of assets, or of profitability compared to debt, is a good thing.
A July 2011 analysis of European insurance firms by consulting firm Bain highlights how solvency ratios affect firms and their ability to survive, how they put investors and customers at ease about their financial health and how the regulatory environment comes into play. The report details that the European Union is implementing more stringent solvency standards for insurance firms since the Great Recession. The rules are known as Solvency II and stipulate higher standards for property and casualty insurers, and life and health insurers. Bain concluded that Solvency II “exposes considerable weaknesses in the solvency ratios and risk-adjusted profitability of European insurers.” The key solvency ratio is assets to equity, which measures how well an insurer’s assets, including its cash and investments, are covered by solvency capital, which is a specialized book value measure that consists of capital readily available to be used in a downturn. For instance it might include assets, such as stocks and bonds, that can be sold quickly if financial conditions deteriorate rapidly as they did during the credit crisis.
A Brief Company Example
MetLife (NYSE:MET) is one of the largest life insurance firms in the world. A recent analysis as of October 2013 details MetLife's debt-to-equity ratio at 102%, or reported debt slightly above its shareholders’ equity, or book value, on the balance sheet. This is an average debt level compared to other firms in the industry, meaning roughly half of rivals have a higher ratio and the other half have a lower ratio. The ratio of total liabilities to total assets stands at 92.6%, which doesn’t compare as well to its debt-to-equity ratio because approximately two-thirds of the industry has a lower ratio. MetLife’s liquidity ratios are even worse and at the bottom of the industry when looking at its current ratio (1.5 times) and quick ratio (1.3 times). But this isn’t much of a concern given the firm has one of the largest balance sheets in the insurance industry and is generally able to fund its near-term obligations. Overall, from a solvency perspective, MetLife should easily be able to fund its long-term and short-term debts, as well as the interest payments on its debt.
Advantages and Disadvantages of Relying Solely on These 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 analysis. Investors need to look at overall investment appeal and decide whether a security is under or overvalued. Debt holders and regulators might be more interested in solvency analysis, but they still need to look at a firm’s overall financial profile, how fast it is growing and whether the firm is well-run overall.
Credit analysts and regulators have a great interest in analyzing a firm’s solvency ratios. Other investors should use them as part of an overall toolkit to investigate a company and its investment prospects.