Capital Adequacy Ratio vs. Solvency Ratio: An Overview

Both the capital adequacy ratio and the solvency ratio provide ways to evaluate a company's debt versus its revenues situation. However, the capital adequacy ratio is usually applied specifically to evaluating banks, while the solvency ratio metric can be used for evaluating any type of company.

Key Takeaways

  • The capital adequacy ratio (CAR) measures whether a company has a sufficient cushion to deal with potential financial losses.
  • The solvency ratio instead measures whether a company has enough cash on hand to cover its short- and long-term debts and obligations.
  • Together, these two metrics can help an analyst or investor judge the chances that a firm may become insolvent, a precursor to bankruptcy.

The Capital Adequacy Ratio

Also known as the capital to risk assets ratio, the capital adequacy ratio (CAR) essentially measures the financial risk that examines the available capital of a bank in relation to extended credit. It expresses a percentage of the bank’s credit exposures weighted by risk.

Regulators track the progress of a bank's CAR to ensure that the bank can withstand significant —but not unreasonable—losses or fluctuation in revenues. The ratio's primary function is to effectuate efficient and stable financial systems.

The CAR measures two types of capital differentiated by tiers. The first tier involves capital that can be used to absorb loss without requiring a bank to stop trading. The second tier involves capital that can absorb the loss in the event that the bank is forced to liquidate. The calculation for the capital adequacy ratio adds the total of both tiers, and that figure is then divided by the company's risk-weighted assets. As of 2021, the lowest acceptable ratio for a U.S. bank is approximately 8%.

The Solvency Ratio

The solvency ratio is a debt evaluation metric that can be applied to any type of company to assess how well it can cover both its short-term and long-term outstanding financial obligations. Solvency ratios below 20% indicate an increased likelihood of default.

Analysts favor the solvency ratio for providing a comprehensive evaluation of a company's financial situation because it measures actual cash flow rather than net income, not all of which may be readily available to a company to meet obligations. The solvency ratio is best employed in comparison to similar firms within the same industry, as certain industries tend to be significantly more debt-heavy than others.