Solvency ratios measure the ability of a company to pay its long-term liabilities, such as debt and the interest on that debt. In addition to many financial ratios, it is one of the best ways to assess a company’s financial health.
Keep reading for examples of how to calculate solvency ratios, how to use them in your analysis, and how these formulas differ from liquidity ratios.
What Are Solvency Ratios?
Solvency ratios refer to any type of analysis of financial ratios that describes the long-term stability of the business. This analysis demonstrates (or disprove) a firm’s ability to honor its debt obligations.
This analysis also help the business owner keep an eye on downtrends that could suggest the potential for bankruptcy in the future. Analysts are able to examine the relationship between the amount of debt a company carries and its assets and earnings.
Types of Solvency Ratios
- Interest Coverage Ratio
A company’s interest coverage ratio measures how many times its earnings can cover its current interest payments. Basically, it is the margin of safety a company has for paying interest on its debt during a particular time period.
In general, the higher the ratio, the better. If the ratio falls to 1.5 or below, it may indicate that a company has difficulty paying its debts.
Calculation of interest coverage ratio:
Interest Coverage Ratio= EBIT/ Interest Expense
Where:
EBIT=Earnings before interest and taxes
- Debt-To-Assets Ratio
Debt-to-assets ratio measures a company’s total debt to its total assets. It measures a company’s ability to pay off its debt with the assets it has available, based on its financial assets.
Here is the formula for calculating the Debt-to-Asset ratio:
Debt-to-asset ratio= Debt/Assets
The ratio over 1.0 indicates that the company relies heavily on debt to finance its operations and may never be able to meet its obligations.
- Equity Ratio
Alternatively, equity ratios, or equity-to-asset ratios, illustrate how much equity is used to fund a firm rather than debt. The higher the number, the healthier the company. The lower the number, the more debt a company has on its books in relation to equity.
Here is a formula for calculating shareholder equity ratio:
SER= TSE/Total Assets
Where
SER= Shareholders Equity Ratio, TSE= Total Shareholder Equity
Difference Between Solvency Ratio and Liquidity Ratio
Solvency Ratio Vs Liquidity Ratio
It’s sometimes mistaken for liquidity ratios to calculate liquidity ratios. Financial health of a company can be measured in both ways, but they are two different things. Below are a few major differences between the two;
Solvency Ratio | Liquidity Ratio |
Measures financial health of company | Measures financial health of company |
Focuses on long-term stability | Focuses on short-term stability |
Includes all assets, such as inventory | Emphasizes cash and cash-like holdings |
The liquidity ratios evaluate a company’s ability to meet its short-term obligations and turn its assets into cash, while the liquidity ratios measure the company’s long-term health.
While a company with high liquidity could rise to meet sudden financial emergencies, this does not tell an analyst how easily a company will be able to honor all of its debt obligations in the long run.
A company with solid solvency, on the other hand, is secure for the long term, but it’s unclear how it would fare under a sudden cash crunch.
Limitations
It is important to note that all businesses cannot all be measured by the same solvency ratio. When evaluating a firm’s actual long-term financial stability, you need to calculate several different analysis ratios and compare them to the industry average.
When trying to understand the meaning of a company’s solvency ratios, compare them with those of a few of the dominant players in the firm’s sector. A relatively minor deviation from the ratios of dominant players in an industry is likely insignificant. Major differences could pose a problem.
Further, a number isn’t 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.
Conclusions
Solvency ratios are used by prospective business lenders to evaluate an enterprise’s ability to meet its long-term debt obligations. As a measure of financial health, the analysis ratio identifies whether a company’s cash flow is sufficient to cover its long-term liabilities.
Unfavorable ratios can suggest that a company is at risk of defaulting on its debt obligations. Business loans with a favourable interest rate can help reduce indebtedness for companies.