Solvency is a crucial indicator of your company’s long-term financial health. By measuring solvency, you can prevent bankruptcy and understand whether your business can pay its debts.
And, with a clearer understanding of your company’s solvency, you can make better decisions about what strategies you should implement to reduce costs and improve processes. A solvency ratio can provide the insight you need to make these decisions—so let’s take a look at how to calculate it.
Understanding the basics of using solvency ratios
Solvency refers to a business’s current assets against its liabilities—and, therefore, its ability to pay its debts. A ratio is a standard term used in finance and refers to comparing two components in financial statements.
Put together, a solvency ratio measures a company’s ability to meet its financial obligations by measuring cash flow capability rather than only looking at short-term commitments. With this, the company can better evaluate its ability to pay off long-term debts while paying interest.
In essence, solvency ratios help you detect whether a business will remain solvent over a long period. So, when looking at your company’s solvency ratios, you can gain insight on questions like:
- How long will the company last in its current state?
- How much debt is the company in?
- How long of a run rate does the company have?
- What decisions can we make now based on where we’re standing?
Business leaders often use the solvency ratios to create a financial picture of a company’s debt obligations. Prospective lenders also use solvency ratios to evaluate a company’s creditworthiness. Additionally, solvency ratios are a reliable way to help business owners understand the company’s ability to manage its operations into the foreseeable future.
But what exactly is the ratio?
A higher ratio indicates stability in that cash flow is sufficient to meet the company’s liabilities. A low ratio, on the other hand, often indicates financial weakness. It shows that the company might have outstanding debt or more debt than it can handle paying off.
Acceptable solvency ratios differ based on the industry, so investors usually compare companies within the same industry rather than assessing them in isolation.
Pros and cons of relying on solvency ratios
While a solvency ratio is an important metric to analyze, it has advantages and disadvantages. Here are some of the most prominent ones that you should keep in mind when deciding to use a solvency ratio to help measure your business’s health:
Advantages
- Long-term financial health: Solvency ratios enable investors and analysts to measure long-term financial health. It represents the value of a company’s assets against the value of liabilities, showing how much cash the company has available to meet financial commitments.
- Performance analysis: Solvency ratios can be a useful way for analysts and investors to examine a company’s performance. These ratios can provide investors and business owners with insight as they compare historical data about these ratios with present information for a look at how a company could be trending in the future.
- Attracts investment: Investors utilize solvency ratios to make investment decisions. If a company’s solvency ratio is high, it indicates the company can pay its debts. This, in turn, creates a positive company perception across investors and can help increase the share price.
Limitations
- Extensive process: A single ratio won’t create a clear picture of a company’s solvency; it needs to be coupled with different solvency ratios to achieve a practical evaluation. Investors and business owners can use multiple solvency ratios to determine a company’s solvency, but doing this can be a complicated and time-consuming process since various factors come into play.
- New funds: Solvency ratios do not consider the company’s ability to raise cash and long-term capital. Typically, companies raise capital by either issuing bonds or shares. Solvency ratio calculations omit this input, which means you won’t get the complete picture of how well a company can meet its debt obligations.
Liquidity ratios: The other side of the same coin
There are probably thousands of terms you’ve heard as a business owner, accountant, or investor—and two common ones you’ve likely heard of include “solvency ratio” and “liquidity ratio.” If you’re unfamiliar with these business formulas, you should know: they aren’t the same.
A solvency ratio is a metric stakeholders use to determine a company’s financial health by measuring its cash flow capability in covering long-term debt. Conversely, a liquidity ratio focuses on how quickly a company can turn its assets into cash. This includes inventory, investments, and accounts receivable.
How to calculate solvency ratios
There are various solvency ratios you can use. Some of them are more technical and tailored toward auditors. Others are valuable tools for business owners, accountants, and investors. There are five main solvency ratios used, including:
- Long-term debt-to-equity ratio
- Total debt-to-equity ratio
- Financial leverage ratio
- Debt ratio
- Proprietary ratio
In this article, we’ll examine the impact and use of debt-to-assets ratio and the debt-to-equity ratio as examples of common solvency ratios.
Formula #1: Debt-to-assets ratio
The debt-to-assets ratio shows the degree to which a company uses debt to finance its assets. You can calculate the debt-to-assets ratio by dividing a company’s total debt by its total assets. Here’s the formula in action:
Say a company has a total debt of $120,000 and total assets valued at $240,000. We would plug in those numbers and get .5 as our debt-to-assets ratio:
$120,000 / $240,000 = 0.50
Since the company’s debt-to-assets ratio is 0.5, it means that 50% of the company’s assets were financed by debt.
Companies with a high debt-to-asset ratio are less liquid and pay higher interest rates. As a general rule, investors look at companies that fall in the range of 0.3 to 0.6 for the debt-to-asset ratio, which is ideal. Anything below a ratio of “1” is safe while anything above “2” is classified as very risky.
Formula #2: Debt-to-equity ratio
The debt-to-equity solvency ratio assesses how much of your company is financed by debt or equity—and the extent to which shareholder’s equity can fulfill any outstanding obligations to creditors (in the event a business declines).
Here’s the formula for it:
If a company has $1.8 million in total liabilities while its total equity is $1.2 million, we would get a ratio of:
For context, a ratio of 1 to 1.5 is too low to be considered favorable. Instead, you should aim to see 2 or 2.5 for this solvency ratio.
Now, keep in mind that a high debt-to-equity ratio doesn’t necessarily mean that a business can’t pay off debt. Yes, it’s more heavily reliant on debt—and this could be risky because it could become over-leveraged. But that doesn’t necessarily mean that they wouldn’t be able to pay off that debt through other sources if creditors came calling.
Similarly, a lower debt-to-equity ratio isn’t necessarily risky as a number of successful, capital-efficient companies are also self-financed.
Why are solvency ratios important?
Solvency ratios aren’t just useful tools—they’re necessary metrics for gauging a company’s financial health and understanding its ability to meet its debt obligations.
Let’s take a look at how solvency ratios can help you gain valuable insights about your business.
Reason #1: Be proactive in managing your company’s health
Solvency ratios have been designed to measure a company’s overall profitability compared to its financial obligations. Staying on top of what’s happening with your company’s finances helps you take the proper steps to address any red flags as they happen rather than months or years down the line.
But it’s important to point out here that solvency ratios on their own will not provide a full financial picture of a company. This is why typically they are used together with other financial ratios and trend analysis to best assess the financial standing of a company.
Reason #2: Ensure financial stability
Solvency ratios measure all debt—short and long-term—to help you determine your company’s solvency state. In essence, these ratios provide a top-down financial view of a company’s financial health.
In turn, this helps business owners monitor how well the company is doing—whether, for example, a bankruptcy is possible or if an over-leveraged position can be salvaged. For investors and analysts, looking at a company’s debt obligations can also sometimes provide oblique investment opportunities.
Reason #3: Secure financial leverage
Solvency ratios help assess the total leverage of a company. This information allows analysts to track all debts to determine cash flow and provide accurate financial evaluations—which is essential for business presentations, loan applications, and appealing to investors.
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Figuring out your company’s financial standing is the first step to success. Solvency ratios help with that by giving business leaders the tools to strategize better and make the best investment opportunities given their current status.
But lots of manual work is required to calculate solvency ratios. Automating outgrown and manual processes allow you to digitize paper-based processes and let your company focus on what matters the most—your business and its customers.
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