When it comes to indicators of a company’s financial health, a solvency ratio is a significant one. It is a crucial measure of a company’s ability to manage debt in the long-term and is primarily used by businesses and lenders to understand the sufficiency of cash flow.
Understanding solvency ratios
Understanding the solvency ratio is a great way to gain insights into a company’s ability to remain solvent in the long run. Instead of taking into account a company’s net income, a solvency ratio looks at the actual cash flow in the company, accounting for depreciation and non-cash expenses. These considerations make this financial assessment tool quite comprehensive and reliable. It is used by potential investors and lenders to analyse a company’s financial health.
When calculating the solvency ratio, all the liabilities of a business are pitted against the cash flow capacity to attain a long-term outlook. Solvency ratios are different among various industries and are thus most valuable when studied over time and compared to competitors.
In the context of insurance companies, the solvency ratio compares the size of a company’s capital in relation to its premiums. For the insurer, this indicates the risk of facing claims that they may not be able to cover.
Also read: Price to earnings ratio
Different types of solvency ratios
There are primarily four kinds of solvency ratios. These are discussed below.
Interest coverage ratio
The formula for calculating this is:
Interest coverage ratio = (Earnings before taxes and interest)/(Interest expenses)
This solvency ratio calculates the exact number of times a given company can comply with interest payments based on its current level of earnings. This can also be considered as a safety margin that a company possesses and maintains. A high interest coverage ratio is a good sign. If this falls below 1.5, a company may face problems paying interest on its debt.
Debt-to-assets ratio
This is calculated by dividing a company’s debt by its assets. This measures the leverage a company has and what amount of its funding is rooted in debt compared to its assets. Naturally, this also indicates the propensity of a company to settle its debts with the assets it has. If the debt-to-assets ratio is more than 1, it signifies that the company has more debt than assets and could possibly have problems paying off its liabilities in the future.
Also read: Price to book ratio
Equity ratio
This is also known as the shareholder equity ratio. The formula to calculate it is:
Shareholder equity ratio = (Total shareholder equity)/(Total assets)
Instead of debt, the shareholder equity ratio (SHR) calculates the equity that funds a company. A higher SHR is indicative of good financial health, and a lower SHR signifies that the company has more debt in relation to equity.
Debt-to-equity ratio
The formula for calculating this is:
Debt to equity ratio = (Outstanding debt)/Equity
Much like the debt-to-assets ratio, this ratio indicates how much of a company’s funding comes from debt and what percentage of this debt can be paid off with equity in case the company needs liquidity. A high debt-to-equity ratio indicates a high amount of liabilities and, thus, a high chance of a default.
Differences between solvency ratios and liquidity ratios
Solvency and liquidity ratios measure a company's financial health but differ in their focus. A solvency ratio provides a long-term perspective, evaluating a company's capability to meet long-term debts like bonds. On the other hand, the liquidity ratio is a measure of short-term financial stability as it examines highly liquid assets, like cash, to cover immediate obligations. As an investor, if you want to study a company's ability to pay short-term bills, liquidity ratios will be more helpful to you. Conversely, to study a company’s long-term financial health, you should look at solvency ratios.
Also read: PEG ratio
Drawbacks of solvency ratios
Even with low levels of debt, bad policies surrounding cash management in a company can lead to a weak position when it comes to solvency. Let us assume you have calculated a solvency ratio for a company you want to invest in. On its own, the number may not mean much and can only give you limited insights.
Thus, it is important to look at these financial indicators in conjunction with other metrics and historical data, and compare them with other competitors to get a clear overall picture of a company’s financial health.
Different ways to calculate a solvency ratio
A solvency ratio measures a company's cash flow against its debt obligations and includes depreciation and non-cash expenses. Key metrics to calculate the solvency ratio include the debt-to-assets ratio, interest coverage ratio, equity ratio, and debt-to-equity ratio.
Is a high solvency ratio good?
Typically, a high solvency ratio is a good sign. However, an abnormally high solvency ratio could be a sign that a company is unable to use low-cost debt as it ideally should. While the solvency ratio is a good indicator of a company’s financial health, it can also be used to understand its operational efficiency and overall finances.
Also read: Put call ratio
Solvency vs debt
Solvency is a concept that is tied to debt, but it is completely different. Solvency is a measure of a company’s ability to settle its debt. To maintain steady long-term growth, managing solvency is essential for all companies.
Conclusion
The solvency ratio is essential for assessing a company's long-term financial health and capacity to meet debt obligations. By evaluating cash flow against liabilities, a solvency ratio provides a comprehensive view of financial stability. Major solvency ratios, including interest coverage, debt-to-assets, equity, and debt-to-equity, contain valuable insights for both investors and lenders. Thus, understanding solvency ratios is crucial for making informed investment decisions and ensuring sustainable business growth.
