Solvency Ratios: What They Are and How to Calculate Them

Solvency ratios measure the ability of a company to pay its long-term liabilities, such as debt and the interest on that debt. LinkedInwithBackground BusinessFinance SmallBusiness WhatAreSolvencyRatios? HowtoCalculateSolvencyRatios TableofContents Expand TableofContents WhatAreSolvencyRatios? HowDoYouCalculateSolvency? HowSolvencyRatiosWork Solvencyvs.Liquidity LimitationsofSolvencyRatios By RosemaryCarlson FullBio LinkedIn RosemaryCarlsonisanexpertinfinancewhowritesforTheBalanceSmallBusiness.Shehasconsultedwithmanysmallbusinessesinallareasoffinance.Shewasauniversityprofessoroffinanceandhaswrittenextensivelyinthisarea. Learnaboutour editorialpolicies UpdatedonJuly15,2020 TheBalance Solvencyratiosmeasuretheabilityofacompanytopayitslong-termliabilities,suchasdebtandtheinterestonthatdebt.It'soneofmanyfinancialratiosthatcanbeusedtoassesstheoverallhealthofacompany. Keepreadingforexamplesofhowtocalculatesolvencyratios,howtousetheminyouranalysis,andhowtheseformulasdifferfromliquidityratios. WhatAreSolvencyRatios? Solvencyratiosareanyformoffinancialratioanalysisthatmeasuresthelong-termhealthofabusiness.Inotherwords,solvencyratiosprove(ordisprove)thatbusinessfirmscanhonortheirdebtobligations. Solvencyratiosalsohelpthebusinessownerkeepaneyeondowntrendsthatcouldsuggestthepotentialfor bankruptcyinthefuture.Ithelpsanalystskeepacloseeyeonhowmuchdebtacompanyistakingonincomparisontoitsassetsandearnings. Ifdebtincreaseswithoutcorrespondingupticksineitherassetsorearnings,itcouldbeabadsignofthingstocome. HowDoYouCalculateSolvencyRatios? Thereareseveralsolvencyratiosthatanalystscanuse.Someoftheseratiosaretechnical—ofuseprimarilytoauditorsorcorporateanalysts.Othersareeasilyassessedbyaccountants,businessowners,andinvestorsalike.Herearethreesimpleequationstobeginyoursolvencyratioanalysis. Debt-to-AssetsRatio Thedebt-to-assetsratio measureshowmuchofthefirm'sassetbaseisfinancedusingdebt.Youcalculatethisbydividingacompany'sdebtbyitsassets.Ifafirm'sdebt-to-assetsratiois0.5,thatmeans,forevery$1ofdebt,thereare$2worthofassets. EquityRatio Thisratioiscalculatedbydividingtotalequitybytotalassets.Thistellsanalystshoweffectivelyacompanyfundsitsassetswithshareholderequity,asopposedtodebt.Thehighertheratio,thelessdebtisneededtofundassetacquisition. Interest-CoverageRatio This measuresacompany'sabilitytomeetitslong-termdebtobligations.It'scalculatedbydividingcorporateincome,or"earnings,"beforeinterestandincometaxes(commonlyabbreviatedEBIT)byinterestexpenserelatedtolong-termdebt.Aratioof1.5orlessisgenerallyconsideredatroublingnumber. HowSolvencyRatiosWork Ifoneoftheratiosshowslimitedsolvency,thatshouldraisearedflagforanalysts.Ifseveraloftheseratiospointtolowsolvency,that'samajorissue,especiallyifthebroadereconomicclimateisfairlyupbeat.Acompanythatstruggleswithsolvencywhenthingsaregoodis unlikelytofarewellinastressfuleconomicenvironment. Forbusinessowners,itshouldspuranefforttoreducedebt,increaseassets,orboth.Forapotentialinvestor,theseareseriousindicationsofproblemsahead,andatroublingsignaboutthedirectionthestockpricecouldtake.Tradersmayeventakethisasasigntoshortthestock,thoughtraderswouldconsidermanyotherfactorsbeyondsolvencybeforemakingsuchadecision. DifferenceBetweenSolvencyRatiosandLiquidityRatios SolvencyRatiosvs.LiquidityRatios SolvencyRatios LiquidityRatios Measuresfinancialhealthofcompany Measuresfinancialhealthofcompany Focusesonlong-termstability Focusesonshort-termstability Includesallassets,suchasinventory Emphasizescashandcash-likeholdings Solvencyratiosaresometimesconfusedwithliquidityratios.Bothassessacompany'sfinancialhealth,buttheyaren'tthesamething. Solvencyratiosassessthecompany'slong-termhealthbyevaluatinglong-termdebtandtheinterestonthatdebt;liquidityratiosassessthecompany'sshort-termabilitytomeetcurrentobligationsandturnassetsintocashquickly. Acompanywithhighliquiditycouldeasilyrisetomeetsuddenfinancialemergencies,butthatdoesn'ttellananalysthoweasilyacompanycanhonorallofitsdebtobligationsonadecades-longtimeline.Conversely,acompanywithsolidsolvencyisonstablegroundforthelong-term,butit'sunclearhowitwouldfairunderasuddencashcrunch. Byusingbothsolvencyratiosandliquidityratios,analystscandeterminehowwellacompanycanmeetanysuddencashneedswithoutsacrificingitslong-termstability. LimitationsofSolvencyRatios There'snoone-size-fits-allsolvencyratio.Toevaluateagivenfirm'sactuallong-termfinancialstability,youneedtocalculateseveraldifferentsolvencyratiosandcomparethemwithindustryaverages. Onewayofquicklygettingahandleonthemeaningofacompany'ssolvencyratiosistocomparethemwiththesameratiosforafewofthedominantplayersinthefirm'ssector.Relativelyminordeviationsfromtheratiosofthedominantplayersinanindustryarelikelyinsignificant.Majordifferencescouldbeaproblem. Evenwithadiversesetofdatatocompareagainst,solvencyratioswon'ttellyoueverythingyouneedtoknowtoassessacompany'ssolvency.Theseratiosdon'taddresshowdebtisspecificallybeingused.Investmentsinlong-termprojectscouldtakeyearstocometofruition,withsolvencyratiostakingahitinthemeantime,butthatdoesn'tmeantheywerebadinvestmentsforthecompanytomake. KeyTakeaways Solvencyratiosmeasurehowcapableacompanyisofmeetingitslong-termdebtobligations.Calculatingsolvencyratiosisanimportantaspectofmeasuringacompany'slong-termfinancialhealthandstability.Solvencyratiosaredifferentthanliquidityratios,whichemphasizeshort-termstabilityasopposedtolong-termstability. ArticleSources QuickBooks."WhatSolvencyIsandHowItSolvesYourFinancialWoes."AccessedJuly15,2020. CorporateFinanceInstitute."EquityRatio."AccessedJuly15,2020. Share Tweet Share Email RatiostoAssessaCompany HowDoYouDoFinancialStatementAnalysis? ImportantRatiosforCashFlowAnalysis WhattheDebt-to-AssetRatioCanTellYouAboutYourCompany WhatIsFinancialRatioAnalysis? LiquidityRatiosforBusinessInsights WhatAreBusinessLiabilities? ManageYourFirmWithThisFinancialRatioAnalysisTutorial WhatIstheAcidTestRatio? WhatIsAssetBasis? WhatIsNetWorkingCapital? GiveYourBusinessaHealthCheckupwithTheseFinancialRatios WhatIstheCashRatio? The3TypesofAccountinginSmallBusiness TheDebt-to-EquityRatio:MeasuringFinancialRisk WhatIsCapitalinBusiness?