Solvency Ratio - FundsNet

The solvency ratio measures a company's ability to pay its debt and other financial obligations with its cash flow. SolvencyRatioDeniseElizabethPSeniorFinancialEditor&ContributorSeeallarticlesLastUpdated:September8,2021DatePublished:September8,2021Inthepursuitofmoreprofitsandgrowth,acompanywillhavetolookforsourcesoffunds.Onesourceoffundsisdebts.Ofcourse,havingdebtmeanshavingobligationstopay,andcreditors/lenderswillhavetoassessacompany’sabilitytopaybeforelendingtheircashtoacompany,lesttheyrisklosingtheirmoney.Thisabilitytopayallobligations,beitshort-termorlong-term,iswhatwerefertoassolvency.Whenacompanyisconfidentthatitcanpayallofitsdebtobligationswhentheybecomedue,thenthatcompanyknowsthatit’ssolvent.Buthowexactlydoesacompanyknowsthatitissolvent?Asimpleglanceatacompany’sbalancesheetmaygiveyouanideaofacompany’ssolvency.Butotherthanthat,therearemetricsthatspecificallymeasureacompany’ssolvency.Thesemetricsarewhatwecallsolvencyratios.Whataresolvencyratios?Asalreadymentioned,solvencyratiosaremetricsthatmeasureacompany’ssolvency.Theseratiosaresimilartoliquidityratiosinthattheymeasureacompany’scapabilitytopayitsdebts,butratherthanjusttheshort-term,solvencyconsidersalldebtsobligations.Inshort,liquidityrelatestoshort-termdebts,whilesolvencyreferstoshort-termandlong-termdebts.Inaway,solvencyratiosassessacompany’slong-termfinancialhealth.Acompanywithgoodsolvencyratiosmeansthatthecompanyissolventandwillhavenotroublepayingitsdebts.Ifoneorsomeofthesolvencyratiosaren’tgoodthough,thismayindicatethatacompanyhassomeareasinwhichitssolvencyislacking.Ifallofacompany’ssolvencyratiosaren’tgood,thenthatcompanymightgointobankruptcyifthesolvencyissuesaren’tfixed.Solvencyratioscanalsobereferredtoasleverageratios.Thecommonlyknownsolvencyratiosinclude:SolvencyRatioThesolvencyratiomeasuresacompany’sabilitytopayitsdebtandotherfinancialobligationswithitscashflow.Thisissimilartotheoperatingcashflowratio(aliquidityratio)inthatitusesacompany’scashflowasameasurement.Themaindifferenceisthatthesolvencyratioconsidersallliabilitiesratherthanjustcurrentliabilities.Acompanywithalowsolvencyratiocouldmeanthatthatcompanyisathighriskofdefault.Thisisaturn-offforcreditorsandpotentialinvestorsaslendingorinvestingtheirmoneytosuchacompanycouldmeanthattheywon’tbegettingtheirmoneyback.Ontheotherhand,acompanywithahighsolvencyratioismorelikelyabletopayoffallitsdebts,whichmakesthemmoreattractivetolendersandinvestors.Thelevelofadequateorgoodsolvencyratiodependsontheindustrythatacompanybelongsin,butingeneral,asolvencyratioof20%orhigherisalreadyconsideredgood.Thesolvencyratiocanbecomputedusingtheformula:SolvencyRatio=NetIncome+Non-cashExpensesTotalLiabilities*Non-cashexpensesincludedepreciationandamortizationLet’strycomputingthesolvencyratiousingtheformulaabove.FromthefinancialstatementofLLcompany,wegatheredthefollowinginformation:LLCompanyNetIncome     33,500.00DepreciationExpense      5,150.00AmortizationExpense      3,300.00TotalLiabilities    150,000.00Usingtheformulaabove,wearriveat:SolvencyRatio=(NetIncome+Non-cashExpenses)/TotalLiabilitiesSolvencyRatio=(33,500+5,150+3,330)/150,000SolvencyRatio=41,950/150,000SolvencyRatio=0.28or28%Aspercomputation,LLcompany’ssolvencyratiois0.28or28%.Thismeansthatitcanpayoff28%ofitstotalliabilitieswithjustitscashflowalone,andifthislevelofsolvencyratioiskeptconstant,thenLLcompanymightbeabletopayoffitsdebtsinmoreorless3.6years.Debt-to-AssetsRatioAlsoknownsimplyastheDebtRatio,thedebt-to-assetsratiomeasuresthelevelofdebtacompanyhasrelativetoitsassets.Itcanalsobeviewedasthepercentageofassetsthatarefinancedbydebt.Mostcompanieshaveamixofdebtandequityfortheirfinancingstructure.Whilethereisnostandardfortheappropriatemixofdebtandequity,it’sstillagoodideaforacompanytoknowitsdebt-to-assetsratio.Ahighdebt-to-assetsratiowouldmeanthatacompanyisskewedmoretowardsdebtfinancingratherthanequityfinancing.Thisisnotanissueifacompanycanproduceenoughincometocompensateforthecostofdebt(e.g.interestexpense).However,ifacompanyhashistoricallyinconsistentlevelsofprofits,itmightbeagoodideatoloweritsdebt-to-assetsratio.Ifacompany’sdebt-to-assetsratioismorethan1.0(e.g.1.1or110%),thenthatmeansthatacompanyhasmoreliabilitiesthanassets.Ingeneral,thisisnotagoodpictureasitmightmeanthatthecompanyishavingdifficultiesinpayingoffitsdebts.Itcouldalsomeanthatthecompanyisnotdoingagoodjobinutilizingthefundsitgotfromdebtfinancingasitwasnotabletoconvertthemintoadditionalassets.Tocomputethedebt-to-assetratio,thefollowingformulaisused:Debt-to-AssetsRatio=TotalLiabilities/TotalAssetsLet’sgobackLLcompanyexampleabovewhichhasatotalliabilitiesof$150,000.Let’ssaythatLLcompanyhastotalassetsof$300,000.Usingtheformulaabove,wecomputeforLLcompany’sdebt-to-assetsratio:Debt-to-AssetsRatio=TotalLiabilities/TotalAssetsDebt-to-AssetsRatio=150,000/300,000Debt-to-AssetsRatio=0.50or50%Aspercomputation,LLcompanyhasadebt-to-assetsratioof0.50or50%.Thismeansthat50%ofitstotalassetsarebeingfinancedbydebt.Debt-to-EquityRatioSimilartotheDebt-to-AssetsRatio,theDebt-to-EquityRatiomeasuresthelevelofdebtacompanyhas.However,insteadofrelatingittototalassets,it’sabouttherelationshipbetweenacompany’stotalliabilitiesanditstotalequity.Itisalsoaquantitativemeasurementofacompany’sdebt-equitymix.Forexample,ifacompanyhasadebt-to-equityratioof3,thatmeansitsdebt-equitymixis3:1(forevery$1ofequity,thereis$3ofdebt).Adebt-to-equityratioofgreaterthan1meansthatacompanyisfinancedmorebydebtratherthanequity.Ifitislesserthan1,thenacompanyisfinancedmorebyequityratherthandebt.Ifitisexactly1,thenacompanyisequallyfinancedbybothdebtandequity.Thedebt-to-equityratioisalsoanindicatoroftheabilityofacompany’sshareholders’equitytopayoffallofitsoutstandingloansintheextremecaseofabusinessdownturn.Theformulacommonlyusedforcomputingthedebt-to-equityratioisasfollows:Debt-to-EquityRatio=TotalLiabilities/TotalEquity*Therearesomecaseswhereshareholders’equityisusedinsteadoftotalequitywhichissometimesreferredtoastheDebt-to-CapitalRatioLet’ssaythatacompanyhastotalliabilitiesof$100,000andtotalequityof$400,000,andwewanttoknowitsdebt-to-equityratio.Usingtheformulaabove:Debt-to-EquityRatio=TotalLiabilities/TotalEquityDebt-to-EquityRatio=100,000/400,000Debt-to-EquityRatio=0.25or0.25:1or1:4Fromthecomputationabove,wecanseethatthecompanyhasadebt-to-equityratioof0.25.Itcouldalsobeinterpretedasthecompanyhavingadebt-equitymixof1:4.Thismeansthatthecompanyisfinancedmorebyequityratherthandebt.InterestCoverageRatio(ICR)Debtobligationssuchasloansandbondscomewithinterest.Theinterestcoverageratio(ICR)measuresacompany’sabilitytopaysuchinterest.Itisalsoreferredtoastimeinterestearned(TIE)asitmeasuresthenumberoftimesacompanycanpayforitsinterestexpensewithjustitsearnings/operatingincome.Theinterestcoverageratioalsopresentsacompany’smarginofsafetyregardinginterestexpense.WhileanICRof1mayseemenoughasitmeansthatacompanycanpayforitsinterestexpensewithjustitsearnings,rememberthattherearestilltaxestopay.Nottomentionsurprisedipsinrevenue,andyousuddenlydon’thaveenoughearningstocoverallexpenses(includinginterestsandtaxes).AnICRofjust1isnotenough.AcompanyneedstohaveahigherICRforittobecomfortablewithitsfinancialposition.Theformulaforcomputingtheinterestcoverageisasfollows:InterestCoverageRatio=OperatingIncomeorEBITInterestExpenses*EBITmeansearningsbeforeinterestsandtaxes.Let’ssayCompanyZXhasanoperatingincomeof$60,000andaninterestexpenseof$15,000.WecancomputefortheICRbyusingtheaboveformula:InterestCoverageRatio=OperatingIncome/InterestExpenseInterestCoverageRatio=60,000/15,000InterestCoverageRatio=4or4xThismeansthatCompanyZXcancoverforitsinterestexpensewithjustitsearningsatmost4timesbeforeithastotapontoitscashandcashequivalents.AnICRof4canalsobecomfortableenoughtoaccountforunexpecteddipsinrevenueoranyotherfactorsthatcanaffectthecompany’sfinancialwell-being.UsesofSolvencyRatiosSolvencyratiosareusefulforbothinternalandexternalusers.Lenders/creditorsusesolvencyratiostoassesswhetheracompanyiseligibleforaloan.Sincesolvencyratiosmeasureacompany’sabilitytopayallofitsdebtobligations,lenders/creditorscanusethemtoassesswhetheracompanycouldrepaythemshouldtheylendtheirmoney.Acompanywithpoorsolvencyratioswillmostlikelyfindithardtosecurealoanfromlenders/creditors,whereasacompanywithgreatsolvencyratioswillhavenotroublesecuringloans.Ownersusetheseratiostoassessthefinancialwell-beingoftheircompany.Acompanythatcannotpayitsliabilitieswillalwaysbearedflag,beitforcurrentorpotentialinvestors.Ifanownerknowsthatthecompany’ssolvencyisn’tlookinggreat,s/hewillmostlikelyfindwaystoimproveit,suchasinvestingmorecapitalorshyingawayfrommoredebts.Solvencyratioscanalsobeusedbymanagement.Theycanusethemtomakedecisionsregardingdebt,suchasdecidingwhethertopursueadditionaldebtornot.Ifmanagementfindsthathavingmoredebtresultinlessernetincome,theymaysuggesttotheownerstonotpursueadditionaldebts.LimitationsofSolvencyRatiosWhilesolvencyratioscanbeusefultoolsformeasuringacompany’sfinancialwell-being,theyshouldnotbelookeduponinisolation.Forexample,acompanymayhaveahighdebt-to-assetsratio,whichmaybeconsideredtoberiskybymostinvestors,butifithasaveryhighinterestcoverageratio,woulditstillbeconsideredariskycompanytoinvestin?Anotherwouldbeacompanyhavinggoodoverallsolvencyratios,butpoorliquidityratios.Whileyes,suchacompanycananswerforitsdebtsinthelongrun,butifitcannotpayforitsshort-termdebtsintime,woulditstillbeconsideredafinanciallysoundcompany?Solvencyratiosontheirownarejustnumbersandassuch,won’ttellyouthewholestory.Tomakethemostoutofthem,youwouldneedtocomparethemwiththesolvencyratiosofapreviousperiodtoknowifthecompanywasabletomaintainorevenimproveitssolvency.Theyshouldalsobecomparedtoothercompanieswithinthesameindustrytoassesswhetheracompanyiscompetitiveandwithinindustrystandards.Knowingthatacompanyhasadebt-to-equityratioof3:1isnotenoughtoknowifithasadequatedebtlevelsornot.Anotherlimitationofsolvencyratiosisthattheyarecomputedbasedonhistoricaldata.Theseratiosdonotaccountforfuturetransactions.Supposeacompanysuffersanunpredictablegreatlossandasaresult,itssolvencyisjeopardized.Solvencyratioscannotaccountforsuchunpredictability.Whyshouldcompaniescareabouttheirsolvency?Solvencymeansstayingpower.That’swhyacompanyneedstomonitoritssolvency.Ifacompanylosesitsabilitytopayforitsdebts,bankruptcywouldsurelyfollow.Afterthat,dissolutionwilllikelybethenexttohappen.Trackyourcompany’ssolvencyratios!Doingsowillnotonlyprovideyouwithinformationaboutyourcompany’ssolvencybutwillalsohelpyouinreducingtheriskofbankruptcy.Knowingyourcompany’ssolvencyratioscanalsohelpyourcompanydecidewhetherit’sworthittotakeonanotherdebtornot.Havingattractivesolvencyratioswillmakeiteasierforyourcompanytoapplyforloansorseekotherformsofdebtfinancing.Justbemindfulofyourdebtlevels.Staywithintheappropriatelevelofsolvencyratiosandyourcompanywillmorethanlikelystayinbusinessforyearstocome.Howcanyourcompanystaysolvent?Theshortanswertothisquestionistoremainprofitable.Easiersaidthandoneright?Although,makingprofitsisalreadythepurposeofputtingupabusinesssothisanswerisalreadyagiven.Anotherwayofstayingsolventistobemindfulofyourcompany’sdebtlevels.Besuretokeepyouramountofdebtwithinanacceptablelevel.Refrainfromtakinginmoredebtifitcanhurtyourcompany’sprofitgenerationinthelongrun.SolvencyRatiosandLiquidityRatios–aretheythesame?Althoughsolvencyratiosandliquidityratiosaresimilarinthattheymeasureacompany’sfinancialhealth,theyarenotthesame.Liquidyratiosdealmorewithshort-termobligationsandliquidassets.Anexampleofthisisthecurrentratiowhichisanindicationoftherelationshipbetweencurrentassetsandcurrentliabilities.Solvencyratiosontheotherhanddealwiththetotalassetsandtotalliabilities.Justtakealookatthedebt-to-assetsratiowhichisanindicationoftotalassetsandtotalliabilities.Inshort,whilesimilar,theyarenotthesame.Liquidityratiosfocusmoreontheshort-term,whilesolvencyratiosfocusmoreonthelong-term.ArticleSources&CitationsFundsNetrequiresContributors,WritersandAuthorstousePrimarySourcestosourceandcitetheirwork.TheseSourcesincludeWhitePapers,GovernmentInformation&Data,OriginalReportingandInterviewsfromIndustryExperts.ReputablePublishersarealsosourcedandcitedwhereappropriate.LearnmoreaboutthestandardswefollowinproducingAccurate,UnbiasedandResearchedContentinoureditorialpolicy.tsu.edu"FinancialAnalysis"Page1.September8,2021uoregon.edu"FINANCIALSTATEMENTANALYSIS"Page1.September8,2021purdue.edu"MarketValueBalanceSheetandAnalysis"Page1.September8,2021EditorialProcessOurHighlyExperiencedTeamrecommendsProductsorServicesafterthoroughlyresearchingthemtoensureweprovideanunbiased,comprehensivesolutionforyourHomeorBusiness.WeStandbyourReviewsandwhenyouPurchasesomethingwe’veRecommended,thecommissionswereceivehelpsupportourStaffandourResearchProcess.