Formula to Calculate Solvency Ratio
The term “solvency ratio” refers to the measure of the ability of a company to pay off its financial debt obligations. Conversely, the solvency ratio determines whether the cash flow generated by the company is adequate to meet its short term and long term liabilities. The formula for solvency ratio is derived by initially adding back non-cash expenses to the net income and then dividing the result by the summation of short term liabilities and long term liabilities. Mathematically, it is represented as,
Steps to Calculate Solvency Ratio
The formula for the calculation of solvency ratio can be obtained by using the following steps:
Step 1: Firstly, determine the net income of the company from the income statement.
Step 2: Next, determine the non-cash expenses from the income statement again. Primary examples of non-cash expenses are depreciation and amortization expense.
Step 3: Next, figure out the short term liabilities from the balance sheet and it comprises the current portion of the long term debt, short term bank borrowing etc.
Step 4: Next, figure out the long term liabilities from the balance sheet again and it primarily includes long term debt, bonds payable, customer deposits etc.
Step 5: Now, add the value derived in step 1 and step 2 to compute the cash generated by the business. Next, add the value derived in step 3 and step 4 to compute the total liabilities. Finally, the formula for the calculation of solvency ratio is derived by dividing the cash generated by the total liabilities as shown above.
Example of Solvency Ratio
Let’s see some simple to advanced examples of Solvency Ratios to understand it better.
Let us take the example of a company called PQR Ltd for the calculation of the solvency ratio. The following information is available as per the annual report for the year ended on December 31, 2018.
Using the above-given information we will do the calculation of Solvency Ratio as follows,
- Solvency Ratio Formula = ($15,000 + $5,000) / ($25,000 + $35,000)
Solvency Ratio will be –
Solvency Ratio = 33.33%
Let us take the example of Apple Inc.’s annual report as on September 29, 2018, 2017 and 2016. Do the calculation of the solvency ratio on the basis of the available information.
For the calculation of the Solvency Ratio, we will first calculate the following values.
Short Term Liabilities for 2018
Short term liabilities for 2018 = $55,888 Mn + $20,748 Mn + $40,230 Mn
= $116,866 Mn
Similarly, we will calculate the Short term liabilities for 2017 and 2016
Short term liabilities for 2017 = $44,242 Mn + $18,473 Mn + $38,099 Mn
= $100,814 Mn
Short term liabilities for 2016 = $59,321 Mn + $11,605 Mn + $8,080 Mn
= $79,006 Mn
Long Term Liabilities for 2018
- Long term liabilities for 2018 = $93,735 Mn + $45,180 Mn + $2,797 Mn
- = $141,712 Mn
Similarly, we will calculate the Long term liabilities for 2017 and 2016
- Long term liabilities for 2017 = $97,207 Mn + $40,415 Mn + $2,836 Mn
- = $140,458 Mn
- Long term liabilities for 2016 = $75,427 Mn + $36,074 Mn + $2,930 Mn
- = $114,431 Mn
Solvency Ratio for 2018
- Solvency Ratio = ($59,531 Mn + $10,903 Mn) / ($116,866 Mn + $141,712 Mn)
- = 27.24%
Solvency Ratio for 2017
- Solvency Ratio for 2017 = ($48,351 Mn + $10,157 Mn) / ($100,814 Mn + $140,458 Mn)
- = 24.25%
Solvency Ratio for 2016
- Solvency ratio for 2016 = ($45,687 Mn + $10,505 Mn) / ($79,006 Mn + $114,431 Mn)
- = 29.05%
Therefore, it can be seen that despite some variation the last three years, Apple Inc.’s solvency ratio has remained at a fairly comfortable situation.
Solvency Ratio Calculator
You can use the following Solvency Ratio Calculator.
|Solvency Ratio Formula =||
Relevance and Use of Solvency Ratio Formula
It is very important for a credit analyst to understand the concept of solvency ratio because it is one of the few financial ratios utilized to assess if a company can stay solvent. The solvency ratio helps in measuring the solvency of a company comprehensively, as it determines whether the actual cash flow of the company (net income + depreciation and other non-cash expenses) will be sufficient in relation to all the liabilities, both short term, and long term debt. In this way, the solvency ratio helps in the assessment of the long term health of a company by computing its debt repayment ability (principal repayment of long term debt and its interest payment).
The solvency ratio also finds extensive application in the insurance industry, where it is used to compare the size of its capital vis-à-vis the premiums were written and helps in the assessment of the risk that an insurer faces in terms of claims to be covered.
This has been a guide to Solvency Ratio Formula. Here we discuss how to calculate Solvency Ratio along with the practical examples and downloadable excel sheet. You can learn more about accounting from the following articles –