What are Solvency Ratios?
Solvency Ratios are the ratios calculated to judge the organization’s financial position from a long-term solvency point of view. These ratios measure the firm’s ability to satisfy its long-term obligations. Investors closely track them to understand and appreciate the ability of the business to meet its long-term liabilities and help them in decision-making for the long-term investment of their funds in the business.
- Accordingly, SolvencySolvencySolvency of a company means its ability to meet the long term financial commitments, continue its operation in the foreseeable future and achieve long term growth. It indicates that the entity will conduct its business with ease.read more ratios are calculated to judge the financial position to ascertain whether the business is financially sound enough to meet its long-term commitments.
- Solvency Ratios analyze the ability of a business to pay its long-term debt. It is important to note here that the portion of Shareholder’s Funds (Owner’s Equity) out of the total liabilities determines the Solvency of an Organization.
- The higher the Shareholder’s Funds compared to other liabilities of the Organization, the greater the Solvency business enjoys and vice versa.
Table of contents
Key Takeaways
- Solvency ratios reflect a company’s financial standing for the long term. Investors use them to assess the company’s ability to handle debt and make informed investment decisions.
- The purpose of the calculation is to assess the financial status of a company and ascertain whether it possesses sufficient resources to meet its long-term commitments.
- To assess financial stability, consider important solvency ratios like long-term debt-to-equity, total debt-to-equity, debt, financial leverage, and proprietary ratios. Owner’s equity compared to total liabilities also impacts stability.
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For eg:
Source: Solvency Ratios (wallstreetmojo.com)
List of Solvency Ratios
A list of important Solvency ratios are discussed below, followed by a Numerical example:
#1 – Long-Term Debt- to- Equity Ratio
This solvency ratio formula aims to determine the amount of long-term debt a business has undertaken vis-à -vis the Equity and helps find the business’s leverage. The Ratio also helps identify how much Long-term debt a business has to raise compared to its Equity Contribution. Here Long-Term DebtLong-Term DebtLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company's balance sheet as the non-current liability.read more includes long-term loans, i.e., DebenturesDebenturesDebentures refer to long-term debt instruments issued by a government or corporation to meet its financial requirements. In return, investors are compensated with an interest income for being a creditor to the issuer.read more or Long-term loans taken from Financial Institutions, and Equity means Shareholders’ Funds, i.e., Equity Share Capital, Preference SharePreference ShareA preferred share is a share that enjoys priority in receiving dividends compared to common stock. The dividend rate can be fixed or floating depending upon the terms of the issue. Also, preferred stockholders generally do not enjoy voting rights. However, their claims are discharged before the shares of common stockholders at the time of liquidation.read more Capital and Reserves in the form of Retained EarningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more.
Solvency Ratio Formula:
Long Term Debt to Equity Ratio= Long Term Debt/ Total Equity
#2 – Total Debt- to- Equity Ratio
This solvency ratio formula aims to determine the amount of total debt (which includes both short-term debt and long-term debt) a business has undertaken vis-Ã -vis the Equity and helps find the total leverage of the business. The Ratio helps identify how much business is funded by debt compared to Equity Contribution. In a nutshell, the higher the ratio, the higher the leverage, and the higher is the risk on account of a heavy debt obligation (in the form of Interest and Principal Payments) on the part of the business.
Solvency Ratio Formula:
Total Debt to Equity Ratio= Total Debt/ Total Equity
#3 – Debt Ratio
This Ratio aims to determine the proportion of the company’s total assets (which includes both Current AssetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more and Non-Current AssetsNon-Current AssetsNon-current assets are long-term assets bought to use in the business, and their benefits are likely to accrue for many years. These Assets reveal information about the company's investing activities and can be tangible or intangible. Examples include property, plant, equipment, land & building, bonds and stocks, patents, trademark.read more) financed by Debt. It helps in assessing the total leverage of the business. The higher the ratio, the higher the leverage and higher is the financial risk on account of a heavy debt obligation (in the form of Interest and Principal PaymentsPrincipal PaymentsThe principle amount is a significant portion of the total loan amount. Aside from monthly installments, when a borrower pays a part of the principal amount, the loan's original amount is directly reduced.read more) on the part of the business.
Solvency Ratio Formula:
Debt Ratio= Total Debt/ Total Assets
#4 – Financial Leverage
The Financial LeverageFinancial LeverageFinancial Leverage Ratio measures the impact of debt on the Company’s overall profitability. Moreover, high & low ratio implies high & low fixed business investment cost, respectively. read more ratio captures the impact of all obligations, both interest-bearing and non-interest-bearing. This Ratio aims to determine how much of the business assets belong to the Shareholders of the company rather than the Debt holders /Creditors. Accordingly, if Equity Shareholders fund the majority of the assets, the business will be less leveraged than the majority of the assets funded by Debt (in that case, the business will be more leveraged). The higher the ratio, the higher the leverage and the higher the financial risk on the heavy debt obligation taken to finance the business’s assets.
Solvency Ratio Formula:
Financial Leverage= Total Assets/ Total Equity
#5 – Proprietary Ratio
This ratio establishes the relationship between Shareholders’ funds and the business’s total assets. It indicates how much shareholder funds have been invested in the business’s assets. The higher the ratio, the lesser the leverage, and comparatively less is the financial riskFinancial RiskFinancial risk refers to the risk of losing funds and assets with the possibility of not being able to pay off the debt taken from creditors, banks and financial institutions. A firm may face this due to incompetent business decisions and practices, eventually leading to bankruptcy.read more on the part of the business. Conversely, it can be calculated by taking the inverse of the Financial Leverage Ratio.
Solvency Ratio Formula:
Proprietary Ratio= Total Equity/ Total Assets
Solvency Ratios Explained in Video
Example of Solvency Ratios
Let’s understand the above Ratios with the help of a Numerical example for better conceptual clarity:
Alpha and Beta are two companies operating in the same line of business of Leather Shoe Manufacturing, which has furnished certain details from their Balance Sheet at the end of the year. Let’s analyze the Solvency of the two businesses based on the same.
| Particulars | Alpha Company | Beta Company |
|---|---|---|
| Common Stock (1$ par value) (1) | $550000 | $500000 |
| Preferred Stock (2) | $150000 | $200000 |
| Retained Earnings (3) | $800000 | $700000 |
| Total Equity (1+2+3) | $1500000 | $1400000 |
| Current Assets (A) | $1500000 | $1700000 |
| Long Term Assets/ Non Current Assets (B) | $1500000 | $1200000 |
| Total Assets (A+B) | $3000000 | $2900000 |
| Short Term Debt (C) | $600000 | $1000000 |
| Long Term Debt (D) | $900000 | $500000 |
| Total Debt (C+D) | $1500000 | $1500000 |
Now, let’s see the formula and calculation for the Solvency Ratios below:
In the below-given figure, we have done the calculation for various solvency ratios.
| Ratios | Alpha Company | Beta Company |
|---|---|---|
| Long Term Debt to Equity Ratio | Long Term Debt/Total Equity =$900000/$1500000 =0.6 | Long Term Debt/Total Equity =$500000/$1400000 =0.36 |
| Total Debt to Equity Ratio | Total Debt/Total Equity =$1500000/$1500000 =1 | Total Debt/Total Equity =$1500000/$1400000 =1.07 |
| Debt Ratio | Total Debt/Total Assets =$1500000/$3000000 =0.5 | Total Debt/Total Assets =$1500000/$2900000 =0.52 |
| Financial Leverage | Total Assets/Total Equity =$3000000/$1500000 =2 | Total Assets/Total Equity =$2900000/$1400000 =2.07 |
| Proprietary Ratio | Total Equity/Total Assets =$1500000/$3000000 =0.5 | Total Equity/Total Assets =$1400000/$2900000 =0.48 |
Based on the above Ratios, we can observe a few interesting insights:
- Alpha Company has a higher Long-Term Debt to Equity Ratio than Beta Company. Still, a lower Total Debt to Equity ratio compared to Beta is an indication that Beta Company is using more short-term debt financing to fund itself and will be more prone to liquidity risksLiquidity RisksLiquidity risk refers to 'Cash Crunch' for a temporary or short-term period and such situations are generally detrimental to any business or profit-making organization. Consequently, the business house ends up with negative working capital in most of the cases.read more in case the short-term rates move adversely.
- Both the companies have the same level of Total Debt; however, due to increased equity Contribution, Alpha Company has less financial Leverage than Beta Company.
Conclusion
It must be noted that the various Solvency Ratios discussed above should not be seen in isolation but should be considered collectively, which will help stakeholders better understand and appreciate the importance of these ratios and make a better judgment related to the long-term solvency and ability of the business to honor its financial commitments and continue being a value creator.
Frequently Asked Questions (FAQs)
Short-term solvency ratios determine if a company has enough liquid assets to meet short-term obligations. These ratios include the current, acid test, inventory, and accounts receivable turnover ratios.
Solvency ratios differ depending on the industry, but a solvency ratio of 0.5 is generally a good benchmark to aim for.
One way to evaluate a company’s financial stability is by calculating its solvency ratio. This ratio examines whether a company’s cash flow is sufficient to pay its long-term debt. It is a crucial metric for assessing a company’s financial well-being and predicting the possibility of defaulting on its debts.
The frequency of analyzing solvency ratios depends on the company’s specific circumstances and reporting requirements. Large corporations often review solvency ratios quarterly or annually in their financial reporting and planning processes. Smaller businesses may do so less frequently but should monitor their solvency regularly to ensure financial health.
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