Last Updated on September 20, 2023 by BFSLTeam BFSLTeam
Solvency is one of the most important indicators of a company’s financial health. You may have heard of this term often when discussing the strengths or weaknesses of a corporate entity. But what does it really mean? In layman’s terms, solvency is simply the ability of a company to meet its liabilities and financial obligations with the assets it owns. The more assets a company has with respect to its liabilities, the more solvent it is considered to be. While this explains the meaning of solvency, it is essential to quantify this parameter. Only then can you clearly ascertain if a company is adequately solvent and proceed to make an investment decision accordingly. Here is where solvency ratios come into the picture. This article takes a deep dive into the different ratios within this category, the meaning of solvency ratios and how to calculate them easily.
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What is a Solvency Ratio?
A solvency ratio is a numerical indicator that helps assess the financial health of a company and its ability to meet its long-term financial liabilities and obligations. Since there are different types of assets and liabilities that a company may have at different points in its existence, there are different types of solvency ratios that are available.
Investors, lenders, suppliers and other stakeholders regularly make use of solvency ratios to gauge how financially strong a company is. This forms the basis of various key stakeholder decisions like lending money to the entity, investing money in its operations and participating in the company’s supply chain.
From the perspective of a retail investor, you will also have to understand the meaning of solvency ratios and learn how to calculate and interpret them. This is because the company’s financial health is pivotal to determining its future growth prospect, which, in turn, directly affects the demand for the company’s shares in the stock market.
The Different Types of Solvency Ratios
In the context of servicing long-term debts, investors must look at two key aspects of the debt-asset equation. They are:
- The availability of adequate assets in the company to repay its debts
- The prospect of the company generating enough revenue/profits over time to pay off all its debts and become debt-free
To get a clear picture of both these aspects, experts have devised two broad categories of solvency ratios — namely capital structure ratios and coverage ratios. Let’s take a closer look at each of these categories and what they entail before delving into the different solvency ratio formulas.
- Capital Structure Ratios
A company’s capital will typically include both equity and debt components. These are, after all, the two most common ways to finance business operations. Capital structure ratios give you insights into the capital mix of a company and how it evolves or changes with time. The solvency ratios commonly used for this purpose include:
- Debt-to-equity ratio (DE ratio)
- Debt-to-capital ratio
- Debt-to-assets ratio
- Financial leverage
- Coverage Ratios
Coverage ratios are solvency ratios that evaluate whether a company’s income is adequate enough to cover its debt and other financial obligations. It tells you whether the company is generating enough revenue to keep servicing its debts regularly, and eventually become debt-free. The ratios that assess income adequacy include:
- Solvency ratio
- Interest coverage ratio
- Fixed-charge coverage ratio
Solvency Ratios: Formula and Computation
Now that we’ve covered the meaning of solvency ratios and the main categories they belong to, let’s take a closer look at each metric listed above. Check out the solvency ratio formulas, so you can easily compute them to get a better idea of a company’s financial standing before you invest in it.
- Debt-to-Equity Ratio (DE ratio)
The DE ratio compares a company’s debts with its equity. It tells you how much of the company’s debts can be covered by its equity component. A lower DE ratio is preferred because it means that the company has a lower debt than its equity component.
The DE ratio formula is as follows:
| Debt-to-Equity Ratio = (Long-Term Debt + Short-Term Debt) ÷ Total Equity |
- Debt-to-Capital Ratio
The debt-to-capital ratio evaluates the total debt with respect to the total capital. It gives you clarity about the percentage of a company’s financing that is sourced via debt. The higher this ratio is, the riskier because it means the company relies heavily on debt to fund its operations.
This solvency ratio’s formula is:
| Debt-to-Capital Ratio = (Long-Term Debt + Short-Term Debt) ÷ (Long-Term Debt + Short-Term Debt + Total Equity) |
- Debt-to-Assets Ratio
As you may have guessed, this solvency ratio assesses how much debt a company has in relation to its assets. Here too, a lower ratio indicates stronger financial health, because it means the company has more assets than debt.
The formula for the debt-to-assets ratio is shown below:
| Debt-to-Assets Ratio = Total Debt ÷ Total Assets |
- Financial Leverage
This solvency ratio helps you determine how much of a company’s assets belong to its shareholders as opposed to its creditors or lenders. If shareholders fund most of the company’s assets, it means the company is less leveraged than otherwise. And this is a good sign.
On the other hand, if the claim of the creditors on the company’s assets is higher, it means the firm is highly leveraged. Beyond a certain point, this could increase the risk levels for investors. So, it’s crucial to compute this solvency ratio before you invest in a company with a long-term perspective.
The formula for the financial leverage is as follows:
| Financial Leverage = Total Assets ÷ Total Equity |
- Solvency Ratio
This is a type of coverage ratio that is commonly used to identify if a company’s cash flows are enough to service its debts. Essentially, it compares the total cash flow of the company with its total debt obligations. The cash flow includes the company’s net income, adjusted to add back non-cash charges like depreciation and amortisation.
The higher the solvency ratio is, the better. This is because it means the company can service a higher percentage of its debts with its cash flows alone. Typically, a solvency ratio of 50% or higher is a good sign. In some industries and companies, ratios above 30% may also be acceptable. Ultimately, however, it depends entirely on the level of risk that you are willing to take as an investor.
The solvency ratio formula is given below:
| Solvency Ratio = (Net Income + Non-Cash Charges) ÷ (Long-Term Debt + Short-Term Debt) |
- Interest Coverage Ratio
This is another important solvency ratio. It tells you how many times a company’s operating profit can be used to cover its interest expenses. Naturally, the higher the number, the better it is, because it indicates that the company has adequate profits to meet its interest costs. Analysts typically consider an interest coverage ratio of 2 or higher as a good indicator of solvency. However, the minimum acceptable ratio is 1.5.
To compute the interest coverage ratio, you can use the formula shown below.
| Interest-Coverage Ratio = Earnings Before Interest and Taxes (EBIT) ÷ Interest Expense |
- Fixed-Charge Coverage Ratio
This solvency ratio is used to evaluate the ability of a company to pay its fixed charges and obligations. Such costs may include debt interest payments, rent, utility costs and the like. A higher fixed-charge coverage ratio signals that the company is well-positioned to meet these costs over the long term.
This solvency ratio’s formula is:
| Fixed-Charge Coverage Ratio = (EBIT + Fixed Costs) ÷ (Fixed Costs + Interest Expense) |
Conclusion
Solvency ratios are a crucial part of fundamental analysis. If you are a short-term trader, this metric may not be extremely essential for your trading plan. However, if you are in the market with a long-term outlook, it’s imperative to assess the solvency of the company you wish to invest in. This way, you will get a clear picture of the company’s future prospects and understand whether or not the entity can easily service its long-term debt and obligations. Poor solvency ratios are red flags, while healthy solvency ratios combined with other positive fundamental indicators may make the company a good investment for your long-term portfolio.
