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 give an indication of this usage and try to answer the question – “whether a company’s debt is actually bringing value to the company?”
Following are the solvency ratios:
Table of Contents
Solvency Ratio
Solvency ratio as the name itself suggests is a ratio to measure a firm’s ability to remain solvent in long term. It is the key ratio to determine a company’s ability to pay its long-term debt and other debt obligations. For better understanding, let us have a look at its formula:
The formula of solvency ratio is
Solvency Ratio = {Net Income (Profit after Tax) + Depreciation} / {Short-Term Liabilities + Long-Term Liabilities}
If we look closely the numerator is company’s current cash flow & the denominator is company’s total liabilities. Thus we can say that 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 Income | 48,351 |
Depreciation | 10,157 |
Short-term liabilities | 94,318 |
Long-term liabilities | 140,458 |
Short-term + Long-term Liabilities | 94,318+140,458=234,776 |
Solvency Ratio | (48,351+10,157) / 234,776=24.92% |
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 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. is consistently having same business every year, then it will be able to repay all its debts in 4 years (24.92% X 4 years = 100% approx.)
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 are going to be high & it gets difficult for that company to stay afloat. If 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 industry benchmark must be considered for evaluation.
The formula of 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 company’s total capital. For example, a debt-to-capital ratio of 0.50, means 50% of company’s capital is contributed by debt. This ratio has interpretation similar to 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 Debt-to-Capital Ratio & Debt-to-Equity Ratio, higher this ratio, higher the financial risk. For example, a debt-to-asset ratio of 0.60 means 60% of company’s assets are financed with debt, which is not a good indication of financial health.
The formula of 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 one money unit of equity. The higher the financial leverege 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 financial leverage 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. High interest coverage ratio is a sign 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 of 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 equity | 4,309 |
Accrued pension | 5,043 |
Long-term debt | 4,179 |
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 ratio | 4,179/4,309=0.97 |
Debt-to-capital ratio | 4,179/(4,179+4,309) = 49.23% |
Debt-to-assets ratio | 4,179/23,848=17.52% |
Source-CFA level – 1 – Financial Reporting & Analysis
From the above example, we can interpret that –
Interpretation
From 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 Debt-to-capital ratio, we can say that 49.23% of company’s total capital comes from debt. This can be interpreted similar to debt-to-equity ratio and needs further analysis.
From 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, almost 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 reach a conclusion about long-term prospects of any company.^{1}