Solvency ratios are financial metrics that indicate a company’s ability to meet its financial obligations and repay long-term debts. Let’s explore in more detail the importance of this ratio, the key types of solvency ratios, and the precise formulas for calculating them in the article below!
What are solvency ratios?
Solvency ratios are a group of long-term financial metrics used to assess a company’s ability to meet its long-term debt obligations. Unlike liquidity ratios that focus on short-term payment capacity, solvency ratios evaluate the overall financial stability of a business over an extended period.
These ratios indicate whether a company has sufficient resources (such as assets, cash flows, and shareholders’ equity) to sustain operations and repay long-term liabilities when they come due. A company with strong solvency ratios typically has a solid financial foundation, lower dependence on debt financing, and better resilience against market fluctuations.
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Key types of solvency ratios
Below are several key types of solvency ratios that companies use to evaluate overall profitability and financial health:
Debt-to-equity (D/E) ratio
Debt-to-Equity Ratio (D/E Ratio) is an important financial metric used to measure the proportion between the money a business has borrowed (debt) and the money the business has invested from its own equity. This ratio helps assess the level of debt usage in a company’s capital structure and indicates how dependent the business is on external borrowing compared to its own equity.
The formula for calculating the D/E ratio is as follows:
D/E Ratio = Total Debt / Total Equity
Where:
- Total Debt: The total amount of money the business has borrowed, including both short-term and long-term debt.
- Total Equity: The total value of the company’s equity, including shareholder contributions and retained earnings.
Debt-to-assets ratio
The debt-to-assets ratio is a metric that indicates what percentage of a company’s total assets is financed by debt. In other words, it shows how much of the company’s assets have been formed through borrowed funds.
The formula for calculating debt-to-assets ratio is as follows:
Debt-to-Assets Ratio = Total Debt / Total Assets
All the information needed to calculate debt-to-assets ratio is available in the company’s financial statements, specifically in the Balance Sheet.
Interest coverage ratio
This ratio assesses a firm’s capacity to cover its interest payments with Earnings Before Interest and Taxes (EBIT). A higher interest coverage ratio implies that a company’s earnings are sufficient to cover its interest expenses, lowering the danger of default.
Interest coverage ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense
Cash flow-to-debt ratio
This ratio evaluates a company’s capacity to produce enough cash flow from operations to pay down its debt. Accordingly, a high cash flow-to-debt ratio is frequently regarded as a favorable indicator by investors and creditors, showing that the firm is financially secure and has a strong ability to handle its debt.
Cash Flow-to-Debt = Total Debt / Cash Flow From Operations
Share holder-equity ratio (SER)
This ratio helps in knowing how much of the company’s capital is funded by equity compared to the total capital.
Here, if the ratio is higher, the company is in a good financial position. Whereas, if the ratio is lower, the company has less equity compared to debt, which signifies a critical financial position.
Share holder-equity ratio (SER) = Shareholders’ Equity / Total Assets
Why is it important to measure solvency ratios?
When calculating solvency ratios, they help provide us with information about the financial stability of the business. Specifically, a high solvency ratio indicates the company is in a good position to meet its long-term financial obligations. Conversely, a low solvency ratio indicates that the business has limited ability to meet its long-term financial obligations, which could lead to bankruptcy and a lower credit rating.
Limitations of solvency ratios
It cannot be denied that liquidity ratios provide us with important information about a company’s long-term financial health. However, in reality, it still has some limitations that need to be considered. For example, it does not factor in a company’s ability to acquire new funding sources in the long term, such as funds from bonds or stocks. For such a reason, it should be used alongside other types of analysis to provide a comprehensive overview of a business’s solvency.
Solvency ratios vs. Liquidity ratios: What’s the difference?
Both solvency ratios and liquidity ratios are extremely important to evaluate a company’s ability to handle debt obligations. However, there are major areas of difference between as follow:
| Basis for Comparison | Liquidity | Solvency |
| Definition | Liquidity is defined as the business’ ability to pay off current liabilities with current assets | Solvency measures the business’ ability to meet its debts as they fall due for payment |
| Obligation | Short-term liabilities | Long-term obligations |
| What It Describes | How easily assets are converted to cash | How well the business sustains itself in the long run |
| Ratios | The ratios that measure the liquidity of a business are known as liquidity ratios. These include current ratio, acid test ratio, quick ratio etc. | The solvency of the business is determined by solvency ratios. These are interest coverage ratio, debt to equity ratio and the fixed asset to net worth ratio |
| Risk | The risk is pretty low. However, it does affect the creditworthiness of the business | The risk is extremely high as insolvency can lead to bankruptcy |
| Balance Sheet | Current assets, current liabilities and detailed account of every item beneath them | Debt, shareholders’ equity and long-term assets |
| Impact on Each Other | If solvency is high, liquidity can be achieved within a short period of time | If liquidity is high, solvency may not be achieved quickly |
Final thoughts
Through this article, we hope to have addressed readers’ questions regarding information related to solvency ratios. Follow Tipstrade.org to stay updated with the latest financial knowledge!