What Is the Solvency Ratio?
The solvency ratio is a key metric used to measure an enterprise’s ability to meet its debt obligations and is used often by prospective business lenders. The solvency ratio indicates whether a company’s cash flow is sufficient to meet its short-and long-term liabilities. The lower a company's solvency ratio, the greater the probability that it will default on its debt obligations.
The Formula for the Solvency Ratio Is
Solvency ratio=Short−term liabilities+long−term liabilitiesNet after−tax income+non−cash expenses
Liquidity Vs. Solvency
How to Calculate the Solvency Ratio
The solvency ratio is calculated by dividing a company's after-tax net operating income by its total debt obligations. The net after-tax income is derived by adding non-cash expenses, such as depreciation and amortization, back to net income. these figures come from the company's income statement. Short-term and long-term liabilities are found on the company's balance sheet.
What Does the Solvency Ratio Tell You?
The solvency ratio is one of many 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.
The 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 the company’s capacity to stay afloat. It measures this cash flow capacity in relation to all liabilities, rather than only short-term debt. This way, the 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.
As a general rule of thumb, a solvency ratio higher than 20% is considered to be financially sound; however, 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.
The solvency ratio terminology is also used in regard to insurance companies, comparing the size of its capital relative to the premiums written, and measures the risk an insurer faces of claims it cannot cover.
Example of the Solvency Ratio in Use
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.
Take a look at the solvency ratios for Target Corporation and Wal-Mart Stores for the fiscal year ended January 28, 2017.
|Net Income + Depreciation (A)||$5,035||$24,373|
|ST Debt + LT Debt (B)||$23,739||$102,943|
|Solvency Ratio = (A)/(B)||21.21%||23.68%|
Both Wal-Mart and Target have solid solvency ratios lying above 20%. This means that they are able to close out their long-term debt obligations when they come due using operating income. Lenders looking through a company's financial statement will usually use the solvency ratio as a determinant for creditworthiness.
Measuring cash flow rather than net income is a better determinant of solvency, especially for companies that incur large amounts of depreciation on their assets but have low levels of actual profitability.
- The solvency ratio examines a company's ability to meet its long-term obligations.
- This ratio is most often used by prospective lenders when evaluating a company's creditworthiness.
- A higher ratio percentage result indicates a company's increased ability to cover its liabilities over the long term.
Limitations of Using the Solvency Ratio
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.