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What is the Solvency Ratio?

A solvency ratio assesses a company’s capacity to fulfill long-term liabilities and debts. Solvency ratios are frequently utilized by prospective lenders and investors to evaluate a company’s creditworthiness. Solvency ratios differ depending on the industry. By assessing these ratios individually, an analyst might not be able to comprehend a true picture. Moreover,  its competitors in the same industry. Such a comparison will ensure a holistic view of the company and the industry to which it belongs.

The commonly used solvency ratios include interest coverage ratio, debt to equity ratio, debt to asset ratio, and equity ratio. Moreover, these ratios are then compared to liquidity ratios. By combining and comparing the liquidity ratios with solvency ratios, an analyst can understand the company’s ability to meet short and long term liabilities.

Types of Solvency Ratio

  1. Interest Coverage Ratio
  2. Debt to Equity Ratio
  3. Debt to Asset Ratio
  4. Equity Ratio

Interest Coverage Ratio

The interest coverage ratio measures a company’s ability to repay outstanding interest on borrowings. A high interest coverage ratio indicates that a company’s interest expense can be covered several times over. While a low ratio shows that a company is at risk of defaulting on its loan payments. A comparison of profits before non-cash items divided by total liabilities is termed the key solvency ratio.

Formula

Interest Coverage Ratio = EBIT / Interest Expense

Where,

EBIT- Earning Before Interest and Taxes

Debt to Equity Ratio 

The debt-to-equity (D/E) ratio provides a comparison between total liabilities and the shareholder equity of a company. Furthermore, it demonstrates how much leverage a business has over its liabilities. Higher leverage ratios usually imply that the company poses a greater risk to its shareholders or investors. The D/E ratio, on the other hand, is difficult to evaluate for a specific company because acceptable debt levels vary drastically. The investors tend to adjust the D/E ratio to focus on long-term debt. The reason behind such an adjustment is that the risks associated with long-term liabilities differ from the risk exposure associated with short-term debt and payables.

Formula

Debt to Equity Ratio = Outstanding Debt / Total Equity

Debt to Asset Ratio

The debt to assets ratio is a ratio of a company’s debt-financed assets to its total assets. This leverage ratio, when measured over a period of time, demonstrates how a company has expanded and acquired assets over time.

The investors use this ratio to determine whether a company has sufficient finances to meet its present debt obligations. The ratio also demonstrates whether a company can provide a return on investment.

Formula

Debt to Asset Ratio = Total Debt / Total Assets

Equity Ratio

The shareholder equity ratio indicates how much of a company’s assets are supported through stock issuance rather than debt. The closer a company’s ratio gets to 100%, the more assets it has financed with shares instead of debt. The ratio is a long-term indicator of how financially sustainable a company is. The shareholder equity ratio is most useful when compared to peers or competitors in the same industry. Needless to say, every industry has a standard or average level of shareholder equity to assets.

Formula

Equity Ratio = Total Shareholder’s Equity / Total Assets

Limitations of Solvency Ratio

  • A company’s debt may be lower. A company could be unable to manage its cash efficiently. In addition, the accounts payable and other current liabilities are increasing. In such a case the company might face unstable solvency. However, on the other hand, the metrics could suggest otherwise. Hence, it could be misleading to consider the solvency ratio in isolation from other ratios. 
  • The fundamental issue with solvency ratios is that there is no single ratio that gives the best overall picture of a company’s solvency. Other data should be coupled with these ratios to gain a more complete view of a company’s ability to pay its debts on time consistently. This complete set of data must be compared to similar data for the rest of the industry. This will aim in determining how well a company compares to its competitors.
  • Moreover, access to such data of the company and the industry standard might not be available as quick and easy as it sounds. 
  • Solvency ratios do not take into consideration a company’s ability to raise additional and substantial long-term capital. A company can raise funds by either issuing shares or bonds.  These metrics also ignore the existence of current lines of credit that can be used to obtain additional funds on short notice. Such an easy to obtain and short term source of funds could be an overdraft facility from the bank. A  business can easily pay its debts even when its solvency ratios portray a poor view of its capacity to pay.
  • They fail to provide any information on new lines of business that a company is launching. Such new ventures may be generating huge positive cash flow. The ratios, on the other hand, do not disclose whether previous assets are performing ineffectively. Such low performing assets could result in low returns on investment. These issues are critical because they can have an immediate impact on a company’s solvency.

Solvency Ratio vs Liquidity Ratio

The liquidity ratio and solvency ratios seem to be similar. However, there are fundamental differences between these 2 types of ratios. Both of these types of financial ratios will reveal a company’s financial situation.  The solvency ratios aim to provide an insight into a company’s long-term potential. On the other hand, the liquidity ratio focuses on the capability to fulfil the short-term fund requirements and readiness to swiftly convert current assets into cash.

Liquidity ratios demonstrate a company’s ability to satisfy short-term obligations. Solvency ratios show its ability to meet long-term liabilities. A company’s short-term liquidity may appear to be adequate. However, it may be unable to satisfy its longer-term obligations. As a result, a company can appear to be extremely liquid. The reality might be opposite and end up being insolvent in the long run.

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