What Is a Solvency Ratio?
A solvency ratio is a key metric used to measure an enterprise’s ability to meet its long-term debt obligations and is used often by prospective business lenders. A solvency ratio indicates whether a company’s cash flow is sufficient to meet its long-term liabilities and thus is a measure of its financial health. It can indicate the likelihood that a company will default on its debt obligations.
The main solvency ratios are the debt-to-assets ratio, the interest coverage ratio, the equity ratio, and the debt-to-equity ratio.
- A solvency ratio examines a company's ability to meet its long-term debt obligations.
- The main solvency ratios include the debt-to-assets ratio, the interest coverage ratio, the equity ratio, and the debt-to-equity ratio.
- A solvency ratio can indicate the likelihood that a company will default on its debt obligations.
- Solvency ratios are most often used by prospective lenders when evaluating a company's creditworthiness as well as by potential investors.
- Solvency ratios and liquidity ratios both measure a company's financial health but solvency ratios have a longer-term outlook than liquidity ratios.
Liquidity Vs. Solvency
Understanding a Solvency Ratio
A solvency ratio is one of many metrics used to determine whether a company can stay solvent in the long term.
A 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 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, a 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.
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.
A 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 on claims it cannot cover.
Types of Solvency Ratios
Interest Coverage Ratio
The interest coverage ratio is calculated as follows:
Interest coverage ratio = Earnings before interest and taxes (EBIT) / Interest expense
The interest coverage ratio measures the ability of a company to meet the interest payments on its debt with its earnings. Specifically, it measures how many times over a company can meet its interest payment with its current earnings, as such, it includes a margin of safety.
The higher the ratio, the better, and when the ratio reaches 1.5 or below, then it indicates that a company will have difficulty meeting the interest on its debt.
The debt-to-assets ratio is calculated as follows:
Debt-to-assets ratio = Total debt / Total assets
The debt-to-assets ratio measures a company's total debt to its total assets. It measures a company's leverage and indicates how much of the company is funded by debt versus assets, and therefore, its ability to pay off its debt with its available assets.
A high ratio, above 1, indicates that a company is significantly funded by debt and may have difficulty meetings its obligations.
The equity ratio is calculated as follows:
Equity ratio = Shareholder equity / Total assets
The equity ratio shows how much of a company is funded by equity as opposed to debt. The higher the number, the healthier a company is. The lower the number would indicate that a company has more debt on its books.
The debt-to-equity ratio is calculated as follows:
Debt-to-equity ratio = Total liabilities / Total shareholder equity
The debt-to-equity ratio is similar to the debt-to-assets ratio, in that it indicates how a company is funded, in this case, by debt. The higher the ratio, the more debt a company has on its books, meaning the likelihood of default is higher. The ratio looks at how much of the debt can be covered by equity if the company needed to liquidate.
Limitations of a 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.
It's important to look at a variety of ratios to understand the true financial health of a company, as well as understanding the reason that a ratio is what it is. Furthermore, a number itself won't give much of an indication. A company needs to be compared to its peers, particularly the strong companies in its industry, to determine if the ratio is an acceptable one or not.
For example, an airline company will have more debt than a technology firm just by the nature of its business. An airline company has to buy planes, pay for hangar space, and buy jet fuel; costs that are significantly more than a technology company will ever have to face.
Solvency Ratios vs. Liquidity Ratios
Solvency ratios and liquidity ratios are similar but have important differences. Both these categories of financial ratios will provide an indication of the health of a company. The main difference is that solvency ratios are a longer-term outlook on a company whereas liquidity ratios are a shorter-term outlook.