# Solvency Ratio

Review solvency ratios, liquidity ratios, the differences, formulas, and examples. Measure your company's ability to meet its long-term debt obligations.

## What is a Solvency Ratio?

A solvency ratio is a type of accounting metric that highlights a company’s ability to meet its long-term obligations. Solvency ratios are a class of metrics that include debt to equity ratio, debt to asset ratio, and interest coverage ratio.
By contrast, a liquidity ratio is a type of accounting metric that highlights a company’s ability to meet its short-term obligations. We will discuss current ratio, quick ratio, and cash ratio in the section about liquidity ratios below.

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 Ratio Definition

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.

As such, you will hear management and analysts often refer to earnings before interest, taxes, depreciation, and amortization (EBITDA) and earnings before interest and taxes (EBIT). These measures of profitability help understand the underlying ability for a company to generate positive cash flow.

You must combine short-term debt and long-term debt together to get total liabilities of the business.

A high solvency ratio (high debt relative to cash flow) can cause problems for companies. A high ratio means the company has more financial risk and could put off potential investors.
A low solvency ratio (low debt relative to cash flow) can be an opportunity for companies. A low ratio means the company has less financial risk and is attractive to both debt and equity investors.

Here is a list of solvency ratios:

• Debt to Equity Ratio
• Debt to Asset Ratio
• Interest Coverage Ratio

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.

## Debt to Equity Ratio

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.

## Debt to Asset Ratio

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.

## Interest Coverage Ratio

The interest coverage ratio (ICR) formula is:

Interest Coverage Ratio = Earnings before interest and taxes / Interest expense

Remember that earnings before interest and taxes (EBIT) is also called operating profit. The EBIT formula is total revenue minus cost of goods sold (COGS) minus operating expenses (OPEX).
This ratio shows how many times greater your operating profit is than your interest payments for the current period. Note that both of these values are found on the income statement, as opposed to the other solvency ratios that get their data from the balance sheet.

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.

## Solvency Ratio Examples

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

• Operating profit: \$800,000
• Interest expense: \$150,000
• Total assets: \$2,500,000
• Total debt: \$1,000,000
• Shareholders’ equity: \$1,500,000

Debt to Equity Ratio FY2020

• D/E = Debt / Equity
• D/E = \$1,000,000 / \$1,500,000
• D/E = 0.67

Debt to Asset Ratio FY2020

• D/A = Debt / Assets
• D/A = \$1,000,000 / \$2,500,000
• D/A = 0.40

Interest Coverage Ratio FY2020

• ICR = EBIT / Interest expense
• ICR = \$800,000 / \$150,000
• ICR = 5.33x

Company A, Fiscal Year 2021

• Operating profit: \$900,000
• Interest expense: \$180,000
• Total assets: \$2,700,000
• Total debt: \$1,200,000
• Shareholders’ equity: \$1,500,000

Debt to Equity Ratio FY2021

• D/E = Debt / Equity
• D/E = \$1,200,000 / \$1,500,000
• D/E = 0.80

Debt to Asset Ratio FY2021

• D/A = Debt / Assets
• D/A = \$1,200,000 / \$2,700,000
• D/A = 0.44

Interest Coverage Ratio FY2021

• ICR = EBIT / Interest expense
• ICR = \$900,000 / \$180,000
• ICR = 5.00x

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).

## Solvency Ratio vs. Liquidity Ratio

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.

We have an entire page on liquidity ratio. But for a quick overview, here are three ratios that are easy to calculate and important to understand.

#### Current Ratio

Current ratio is a standard view of looking at a company’s liquidity. It looks if all of the company’s current assets can cover its current liabilities. The current ratio formula is:

Current Ratio = Current assets / Current liabilities

Current assets are defined as all short-term assets that will convert to cash within the operating cycle of the business. Examples include cash, cash equivalents, accounts receivable, and inventory.
Current liabilities refer to all short-term liabilities that must be repaid within the operating cycle of the business. Examples include accounts payable, salaries payable, interest payable, and taxes payable.

#### Quick Ratio

Quick ratio is a more strict view. The metric looks at if current assets less inventory (called quick assets) can cover the company’s current liabilities. The quick ratio formula is:

Quick Ratio = (Current assets - Inventory) / Current liabilities

Quick Ratio = Quick assets / Current liabilities

#### Cash Ratio

Cash ratio is the most strict view. The metric looks at if the cash on hand can cover the company’s current liabilities. The cash ratio formula is:

Cash Ratio = Cash / Current liabilities

You will note that the denominator in all of these equations is current liabilities.

## Final Thoughts

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.

For instance, looking at solvency ratios can help you understand if the company is generating enough profit, has the right capital structure, and if they have too many short-term liabilities or long-term liabilities.

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).