Learning how to calculate and interpret solvency ratios is key to understanding the financial health of a business. Business owners, senior executives, equity investors, and lenders will evaluate the trends in these ratios to understand a company’s solvency, the ability to pay its debts.
For example, the CEO of a small business who is looking to raise additional capital would look at these ratios to see if it’s prudent to take on additional debt or if it’s better for the company to raise capital from issuing equity instead.
We will also explore how to understand these ratios in order to judge if a company’s level of financial leverage is appropriate.
Solvency refers to the ability to pay off one’s debts. The opposite of solvency in business is bankruptcy.
In finance and accounting, solvency ratios show how indebted a company is and provides context on how that company compares to competitors in the industry.
A company’s solvency ratio compares cash flow generated by the business to their outstanding debt to understand if the company has too much debt. In order to find the company’s actual cash flow, you must add non-cash expenses like depreciation and amortization back to net income.
You must combine short-term debt and long-term debt together to get total liabilities of the business.
Here is a list of solvency ratios:
To lower a solvency ratio, a company would need to lower its total debt. A company with zero debt would have a debt to equity or debt to asset of 0 would be debt-free.
A good solvency ratio depends on the specific ratio that you are evaluating. With that being said, let’s dive into each metric in more detail.
The debt to equity formula is:
Debt to Equity Ratio = (Short-term debt + Long-term debt) / Shareholders’ Equity
Debt to Equity Ratio = Total debt / Total equity
A company with $1,000,000 of total debt and $1,000,000 in total equity would have a debt/equity ratio of 1.0. As a general rule, a debt/equity ratio of 1.00 to 1.50 is considered good. A ratio above 2.0 would be a cause for concern in more industries.
The debt to asset formula is:
Debt to Asset Ratio = (Short-term debt + Long-term debt) / (Current assets + Noncurrent assets)
Debt to Asset Ratio = Total debt / Total assets
A company with $800,000 in total debt and $1,200,000 in total assets would have a debt/asset ratio of 0.67. That means of the $1,200,000 of assets, 67% are financed with debt and the remaining 33% are financed with shareholders’ equity.
As you can imagine, this is a high level of debt. Generally speaking, companies should strive for a debt/asset below 0.40 and one above 0.60 would be a cause for concern.
The interest coverage ratio (ICR) formula is:
Interest Coverage Ratio = Earnings before interest and taxes / Interest expense
In general, an interest coverage ratio 2.0 is the minimum and investors would prefer to see a ratio that is 3.0 or greater.
Now that we understand these ratios, let’s explore Company A over two fiscal years, 2020 and 2021. We will use this information to calculate all three solvency ratios.
Company A, Fiscal Year 2020
Debt to Equity Ratio FY2020
Debt to Asset Ratio FY2020
Interest Coverage Ratio FY2020
Company A, Fiscal Year 2021
Debt to Equity Ratio FY2021
Debt to Asset Ratio FY2021
Interest Coverage Ratio FY2021
What were the changes from fiscal year 2020 to 2021? We see that operating profit, interest expense, total assets, and total debt increased. Shareholders’ equity was flat. This shows us that all the new assets purchased were financed through debt.
Despite making more operating profit in 2021, the company had a higher debt/equity ratio (which is more risky), a higher debt/asset ratio (which is more risky), and a lower interest coverage ratio (which is more risky).
As mentioned, solvency ratios and liquidity ratios are related. Both provide a view into a company’s financial health and stability. But there are differences too.
Solvency ratios focus on the company’s ability to meet its long-term obligations, where liquidity ratios focus on the company’s ability to meet its short-term obligations.
Current Ratio = Current assets / Current liabilities
Quick Ratio = (Current assets - Inventory) / Current liabilities
Quick Ratio = Quick assets / Current liabilities
Cash Ratio = Cash / Current liabilities
You will note that the denominator in all of these equations is current liabilities.
Solvency ratios are an important tool for operators to keep track of their long-term financial obligations. While simple to calculate, metrics like debt to equity, debt to asset, and interest coverage ratio provide valuable information to executives and investors.
Leverage can be a great tool for management. Leverage, in the form of taking on debt, can increase the company’s cash position and allow investment in growth or new products at affordable rates.
However, too much leverage can make it difficult to stay solvent. We advise stakeholders to pay close attention to the amount of debt and how the interest payments affect the ability for the business to generate cash.
Executives, shareholders, and creditors will want to carefully monitor the company’s cash flow to ensure the business has enough resources to meet its interest and principal payments on the debt. Companies with weak cash flow, low cash balances, or poor management might face bankruptcy in order to solve these problems.
Lastly, solvency ratios are useful for comparing the same company to itself over several accounting periods or to competitors in the same industry.
These ratios vary significantly across industries, so there is less value in comparing the solvency ratio of, for example, Apple (a technology firm) to JP Morgan (a financial services firm).
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