What is the Solvency Ratio
Solvency ratio is 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:
Liquidity Vs. Solvency
BREAKING DOWN Solvency Ratio
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 short-term debt. This way, solvency ratios assesses a company's long-term health by evaluating 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. 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.
The solvency ratio is calculated by dividing a company's cash flow or after-tax net operating income by its total debt obligations. The cash flow is derived by adding non-cash expenses or depreciation back to net income.
Let's examine 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 for their assets but have low levels of actual profitability. Similarly, assessing a company’s ability to meet all its obligations 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.
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.