Solvency Ratio Explained: How to Calculate Solvency Ratios

A solvency ratio is a type of financial ratio that measures a company's ability to meet its long-term liabilities and survive financially over a long period of time. Companies encounter a range of financial obligations as part of their business operations. Some of these are short-term obligations, such as salaries and accounts payable. While important, short-term liabilities can normally be paid using everyday cash flow and current assets. Long-term debt, on the other hand, can be more difficult to pay down. A solvency ratio analysis focuses on a firm's ability to cover these long-term obligations.

Solvency ratios can provide one of the clearest portraits of a company's financial health. A solvency ratio measures various items that appear on a company's balance sheet, including cash on hand, total assets, total liabilities, and equity held by company owners and investors. A solvency ratio can reveal:

• Financial leverage: A highly leveraged company owes a heavy debt to lenders and may have reduced financial maneuverability.
• Profitability: To be profitable in the long term, companies must bring in enough net income to pay down long-term debt. If operating income can only cover salaries and short-term debt, it can point to future insolvency.
• Net worth: Investment bankers try to gauge an accurate picture of a company's assets and debt before making a financial commitment. An accurate solvency ratio can help reveal the true value of a company in the long term.

Several types of solvency ratios exist in the world of corporate finance.

1. 1. Debt-to-equity ratio: A debt-to-equity ratio, or D/E ratio, compares a company's total debt to its owners' total equity. It reveals how much of a company's net worth is financed by debt rather than cash, assets, and accounts receivable.
2. 2. Debt-to-assets ratio: Debt-to-assets ratios contrast a company's debt to its various assets such as cash, equipment (minus depreciation), and intellectual property. Much like a debt-to-equity ratio, this metric shows how much of a company's net worth comes from debt.
3. 3. Interest coverage ratio: The interest coverage ratio compares a company’s earnings before interest and taxes (EBIT) to the company's interest expenses.
4. 4. Equity ratio: In an equity ratio, total shareholder equity is compared to total assets. This helps determine whether the value of a company has been appropriately assessed by its investors.

Each solvency ratio has its own specific inputs.

• Debt-to-equity ratio: A debt-to-equity ratio (D/E ratio) is calculated by dividing total debt liabilities by total equity. The debt-to-equity formula is: Debt-to-Equity Ratio = Total Liabilities / Total Shareholders' Equity.
• Debt-to-assets ratio: A debt-to-assets ratio is nearly identical to the D/E ratio. It is calculated by dividing total debt by total assets. The debt-to-assets ratio formula is: Debt-to-Asset Ratio = Total Debt / Total Assets.
• Interest coverage ratio: You can calculate an interest coverage ratio by dividing a company's earnings before interest and taxes (EBIT) by its interest payments. The interest coverage ratio is: Interest Coverage Ratio = EBIT / Cost of Interest.
• Equity ratio: Equity ratios are created by dividing total shareholder equity by the total assets of a company. The standard equity ratio is: Equity Ratio: Total Shareholder Equity / Total Assets.

Analyzing solvency ratios as part of financial statements and investment bank analyses can help determine a company’s ability to pay off future debt and remain solvent for years to come.

• Debt-to-equity ratio: Ideally, a debt-to-equity ratio should be less than one. A higher ratio indicates that the company is carrying dangerous amounts of debt. Owners and investors may not recoup their investment unless the current ratio is lowered.
• Debt-to-assets ratio: When a debt-to-assets ratio is greater than one, it means the company has borrowed more money than its assets indicate it is worth. This is not unusual for startups, but over time, a business's assets should increase to the point of exceeding company debt.
• Interest coverage ratio: A high ratio indicates that the company makes more than enough money to cover its interest payments. A low ratio indicates that interest payments eat up too much of the company's operating budget.
• Equity ratio: Equity ratios help illustrate whether a company is appropriately valued by its investors. If ownership equity is much greater than the total assets of a company, it may be overvalued.

Solvency ratios and liquidity ratios both compare a company's assets to future financial obligations. Neither focuses on current liabilities; instead, they zero in on long-term debt. Still, there is one key distinction between a liquidity ratio and a standard solvency ratio.

• Liquidity ratios focus on liquid assets. Liquid assets are those that can be quickly sold off or exchanged. The most liquid asset is cash. Another fairly liquid asset is a marketable security—essentially short-term stock that a company can sell to investors with the promise of short-term profit.
• Solvency ratios focus on all assets. Not all assets are immediately liquid. Real estate holdings, stock in other companies, and intellectual property are not easy to convert into cash at a moment's notice. What's more, doing so might damage a company's long-term business plan. Still, such assets help comprise a company's total worth, and as such, they are included in standard solvency ratios.

All investments and investment strategies entail inherent risks and introduce the potential for financial loss or the depreciation of assets. The information presented in this article is for educational, informational, and referential purposes only. Consult a professional investment advisor before making any financial commitments.

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