Loading the player...

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:

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.

(in millions) Target Wal-Mart
Net Income $2,737 $14,293
Depreciation $2,298 $10,080
Net Income + Depreciation (A) $5,035 $24,373
Short-Term Debt $12,708 $66,928
Long-Term Debt $11,031 $36,015
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.

  1. Ratio Analysis

    A ratio analysis is a quantitative analysis of information contained ...
  2. Free Asset Ratio - FAR

    A metric used to determine whether an insurance company has sufficient ...
  3. Solvency Capital Requirement (SCR)

    A solvency capital requirement (SCR) is the amount of funds that ...
  4. Liquidity Ratios

    A class of financial metrics that is used to determine a company's ...
  5. Solvency Cone

    A model that considers the impact of transaction costs while ...
  6. Leased Bank Guarantee

    A leased bank guarantee is a bank guarantee, which is leased ...
Related Articles
  1. Investing

    Financial Analysis: Solvency vs. Liquidity Ratios

    Solvency and liquidity are equally important for a company's financial health.
  2. Investing

    Liquidity Vs. Solvency

    Learn about the differences between these two words and how each one is used in the stock market.
  3. Investing

    Analyzing Oracle's Debt Ratios in 2016 (ORCL, SAP)

    Learn how the debt ratio, debt-to-equity ratio and debt-to-capital ratio are used to evaluate Oracle Corp.'s liabilities, equity and assets.
  4. Investing

    Ratio Analysis

    Ratio analysis is the use of quantitative analysis of financial information in a company’s financial statements. The analysis is done by comparing line items in a company’s financial ...
  5. Investing

    Financial Ratios to Spot Companies Headed for Bankruptcy

    Obtain information about specific financial ratios investors should monitor to get early warnings about companies potentially headed for bankruptcy.
  6. Investing

    Debt Ratios

    Learn about the debt ratio, debt-equity ratio, capitalization ratio, interest coverage ratio and the cash flow to debt ratio.
  7. Investing

    Analyzing Verizon's Debt Ratios in 2016 (VZ)

    Analyze Verizon's key debt ratios, and understand how the company has been able to expand in recent years by safely increasing its debt load.
  8. Investing

    Key Financial Ratios to Analyze The Healthcare Industry

    Examine the health care sector and learn about significant financial ratios used by investors and analysts to evaluate health care companies.
  1. Are solvency ratios more concerned with the short-term or the long-term?

    Learn what solvency is, how to use ratios to determine a company's solvency, and why solvency ratios are concerned with the ... Read Answer >>
  2. What is the difference the operating cash flow ratio and solvency ratio?

    Learn about the operating cash flow ratio and the solvency ratio, what they measure, and the difference between the operating ... Read Answer >>
  3. What are the differences between solvency ratios and liquidity ratios?

    Learn about liquidity ratios and solvency ratios, some examples of these ratios and the main difference between them. Read Answer >>
  4. What is the difference between the cash ratio and the solvency ratio?

    Understand the difference between the cash ratio and the solvency ratio. Learn why a company should be focused on both ratios ... Read Answer >>
  5. What is the difference between the capital adequacy ratio vs. the solvency ratio?

    Understand the different applications for using the capital adequacy ratio and the solvency ratio, which are both equity ... Read Answer >>
  6. What are the advantages and disadvantages of using the total debt to total assets ...

    Learn how the total debt to total assets ratio is beneficial to investors and lenders in assessing the solvency of a company ... Read Answer >>
Hot Definitions
  1. Standard Deviation

    A measure of the dispersion of a set of data from its mean, calculated as the square root of the variance. The more spread ...
  2. Entrepreneur

    An Entrepreneur is an individual who founds and runs a small business and assumes all the risk and reward of the venture. ...
  3. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  4. Perfect Competition

    Pure or perfect competition is a theoretical market structure in which a number of criteria such as perfect information and ...
  5. Compound Interest

    Compound Interest is interest calculated on the initial principal and also on the accumulated interest of previous periods ...
  6. Income Statement

    A financial statement that measures a company's financial performance over a specific accounting period. Financial performance ...
Trading Center