Solvency ratios measure the ability of a company to pay its long-term liabilities, such as debt and the interest on that debt. It's one of many financial ratios that can be used to assess the overall health of a company.
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 are any form of financial ratio analysis that measures the long-term health of a business. In other words, solvency ratios prove (or disprove) that business firms can honor their debt obligations.
Solvency ratios also help the business owner keep an eye on downtrends that could suggest the potential for bankruptcy in the future. It helps analysts keep a close eye on how much debt a company is taking on in comparison to its assets and earnings.
If debt increases without corresponding upticks in either assets or earnings, it could be a bad sign of things to come.
How Do You Calculate Solvency Ratios?
There are several solvency ratios that analysts can use. Some of these ratios are technical—of use primarily to auditors or corporate analysts. Others are easily assessed by accountants, business owners, and investors alike. Here are three simple equations to begin your solvency ratio analysis.
The debt-to-assets ratio measures how much of the firm's asset base is financed using debt. You calculate this by dividing a company's debt by its assets. If a firm's debt-to-assets ratio is 0.5, that means, for every $1 of debt, there are $2 worth of assets.
This ratio is calculated by dividing total equity by total assets. This tells analysts how effectively a company funds its assets with shareholder equity, as opposed to debt. The higher the ratio, the less debt is needed to fund asset acquisition.
This measures a company's ability to meet its long-term debt obligations. It's calculated by dividing corporate income, or "earnings," before interest and income taxes (commonly abbreviated EBIT) by interest expense related to long-term debt. A ratio of 1.5 or less is generally considered a troubling number.
How Solvency Ratios Work
If one of the ratios shows limited solvency, that should raise a red flag for analysts. If several of these ratios point to low solvency, that's a major issue, especially if the broader economic climate is fairly upbeat. A company that struggles with solvency when things are good is unlikely to fare well in a stressful economic environment.
For business owners, it should spur an effort to reduce debt, increase assets, or both. For a potential investor, these are serious indications of problems ahead, and a troubling sign about the direction the stock price could take. Traders may even take this as a sign to short the stock, though traders would consider many other factors beyond solvency before making such a decision.
Difference Between Solvency Ratios and Liquidity Ratios
|Solvency Ratios vs. Liquidity Ratios|
|Solvency Ratios||Liquidity Ratios|
|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|
Solvency ratios are sometimes confused with liquidity ratios. Both assess a company's financial health, but they aren't the same thing.
Solvency ratios assess the company's long-term health by evaluating long-term debt and the interest on that debt; liquidity ratios assess the company's short-term ability to meet current obligations and turn assets into cash quickly.
A company with high liquidity could easily rise to meet sudden financial emergencies, but that doesn't tell an analyst how easily a company can honor all of its debt obligations on a decades-long timeline. Conversely, a company with solid solvency is on stable ground for the long-term, but it's unclear how it would fair under a sudden cash crunch.
By using both solvency ratios and liquidity ratios, analysts can determine how well a company can meet any sudden cash needs without sacrificing its long-term stability.
Limitations of Solvency Ratios
There's no one-size-fits-all solvency ratio. To evaluate a given firm's actual long-term financial stability, you need to calculate several different solvency ratios and compare them with industry averages.
One way of quickly getting a handle on the meaning of a company's solvency ratios is to compare them with the same ratios for a few of the dominant players in the firm's sector. Relatively minor deviations from the ratios of the dominant players in an industry are likely insignificant. Major differences could be a problem.
Even with a diverse set of data to compare against, solvency ratios won't tell you everything you need to know to assess a company's solvency. These ratios don't address how debt is specifically being used. Investments in long-term projects could take years to come to fruition, with solvency ratios taking a hit in the meantime, but that doesn't mean they were bad investments for the company to make.
- Solvency ratios measure how capable a company is of meeting its long-term debt obligations.
- Calculating solvency ratios is an important aspect of measuring a company's long-term financial health and stability.
- Solvency ratios are different than liquidity ratios, which emphasize short-term stability as opposed to long-term stability.