Solvency Ratios

Solvency ratios are useful in measuring a company’s solvency, thereby evaluating the company’s financial health. A company’s solvency is determined by how much money it has borrowed as debt & its ability to repay this debt apart from its regular obligations. A leveraged firm can deliver to its shareholders only if its rate of return on investments financed by debt is greater than its cost of debt. In order to grow, it is inevitable for any company to borrow on interest, but it is important to monitor how the borrowed funds are used. Solvency ratios indicate this usage and try to answer the question – “whether a company’s debt is actually bringing value to the company?”

Solvency Ratio

The name itself suggests a ratio to measure a firm’s ability to remain solvent in the long term. It is the key ratio to determine a company’s ability (debt capacity) to pay its long-term debt and other debt obligations or net debt. For better understanding, let us have a look at its formula:

The formula for solvency ratio is

Solvency Ratio = {Net Income (Profit after Tax) + Depreciation} / {Short-Term Liabilities + Long-Term Liabilities}

If we look closely, the numerator is the company’s current cash flow & the denominator is the company’s total liabilities. Thus, the solvency ratio indicates whether a company’s cash flow is sufficient to meet its total liabilities.

Let’s calculate solvency ratio of Apple Inc. for September 2017

Example –

 Apple (USD in Millions)
Net Income48,351
Depreciation10,157
Short-term liabilities94,318
Long-term liabilities140,458
Short-term + Long-term Liabilities94,318+140,458=234,776
Solvency Ratio(48,351+10,157) / 234,776=24.92%

The solvency ratio is a more comprehensive measure of solvency as it takes into account cash flows instead of net income. It is good to have a high solvency ratio; the higher, the better. In general terms solvency ratio above 20% is good. So in our example, the solvency ratio of 24.92% is solid. It can be said that if Apple Inc. consistently has the same business every year, then it will be able to repay all its debts in 4 years (24.92% X 4 years = 100% approx.)

Solvency Ratio

Before moving ahead, learn What is Solvency?

There are some other measures of solvency in different terms, which are discussed below:

Debt-to-Equity Ratio

The debt-to-equity ratio measures the amount of debt capital that a company has relative to its equity capital. A higher debt-to-equity ratio indicates weaker solvency. If a company has more debt than its equity, then its interest expenses will be high & it gets difficult for that company to stay afloat. If the debt-to-equity ratio=1, then the company has an equal amount of debt & equity. A good debt-equity ratio would be less than 1, but the industry benchmark must be considered for evaluation.

The formula for the debt-to-equity ratio is:

Debt-to-Equity Ratio = Total Liabilities/Shareholder’s Equity

Debt-to-Capital Ratio

The debt-to-capital ratio estimates the percentage of debt in a company’s total capital. For example, a debt-to-capital ratio of 0.50 means 50% of the company’s capital is contributed by debt. This ratio has an interpretation similar to the debt-equity ratio. A higher ratio means lower solvency & higher financial risk.

The formula of debt-to-capital ratio is:

Debt-to-Capital = Total Debt/Total Capital (i.e. debt + equity)

Debt-to-Asset Ratio

This ratio measures the percentage of total assets financed with debt. Similar to the Debt-to-Capital Ratio & Debt-to-Equity Ratio, the higher this ratio, the higher the financial risk. For example, a debt-to-asset ratio of 0.60 means 60% of the company’s assets are financed with debt, which is not a good indication of financial health.

The formula for debt-to-asset ratio is:

Debt-to-Asset = Total Debt/Total Assets

Financial Leverage Ratio

The financial leverage ratio is more commonly known as the leverage ratio. This ratio measures the amount of value of total assets supported for each money unit of equity. The higher the financial leverage ratio, the more leveraged a company is. For example, a financial leverage ratio of 4 means that each USD 1 of equity supports USD 4 worth of assets.

The formula of the financial leverage/equity multiplier ratio is:

Financial Leverage Ratio = Average Total Assets/Average Total Equity

Interest Coverage Ratio

This ratio measures how many times a company’s earnings before interest & taxes (EBIT) can cover its interest payments. A high-interest coverage ratio is a sign of strong solvency. A high-interest coverage ratio also gives assurance to the investors that a company can repay its debt liabilities from operating earnings.

The formula for the interest coverage ratio is:

Interest Coverage Ratio = EBIT/Interest Payments

Learning with an example

Following is an excerpt taken from the financial statements of an internationally renowned company

 2008 (Euros in Millions)
Total equity4,309
Accrued pension5,043
Long-term debt4,179
Other long-term liabilities (Non-interest bearing)1,267
Current liabilities (Non-interest bearing)9050
Total Assets (Total Equity + Liabilities)23,848
Debt-to-equity ratio4,179/4,309=0.97
Debt-to-capital ratio4,179/(4,179+4,309) = 49.23%
Debt-to-assets ratio4,179/23,848=17.52%

Source-CFA level – 1 – Financial Reporting & Analysis

From the above example, we can interpret that –

Interpretation

From the Debt-to-equity ratio, we can interpret that the company’s debt is 97% of equity, i.e., for 1 dollar of equity, the company has USD 0.97 of debt. The company is highly leveraged because it has a very high amount of debt liability. It is important to know if the company is generating enough returns to repay all the debt & interest liabilities.

From the Debt-to-capital ratio, we can say that 49.23% of the company’s total capital comes from debt. This can be interpreted similarly to the debt-to-equity ratio and needs further analysis.

From the Debt-to-assets ratio, we can interpret that only 17.52% of the assets are financed by debt. This actually indicates good financial standing because even though the company is financed by almost 50% debt, nearly 82% of its assets are debt-free.

Furthermore, it is extremely important to understand that ratio analysis is very subjective. An analyst must consider solvency ratios in a broader context. That being said, the ratios of a company must be compared to its competitors as well as industry & sector benchmark ratios. Also, it is important to consider not only solvency ratios but also profitability ratios, liquidity ratios, activity ratios & other valuation ratios of the company. A clear big-picture analysis is required to conclude the long-term prospects of any company.



Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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