What’s it: The solvency ratio is a financial ratio to measure a company’s ability to meet its long-term obligations. To calculate it, we divide the debt relative to the firm’s capital or assets. Or, we compare a company’s ability to generate cash flows with its financial obligations.
Why is the solvency ratio important?
Companies take on debt to support long-term growth. It is an alternative to equity capital. Both (debt and equity capital) form the company’s capital structure.
Lenders can come from banks or other lending institutions. In addition, the company also owes money by issuing debt securities such as medium-term notes and bonds.
When a company has relatively high debt, it has high financial leverage. And high leverage raises the financial risk, namely uncertainty about the company’s ability to cover debt obligations.
Unlike equity, debt results in regular payments. Companies must pay regular interest and principal on the loan when it is due. As a result, they have to keep paying their debts, even when not generating income. If they cannot meet their debt obligations, creditors can take legal steps by filing bankruptcy with the company.
Ideally, companies take on debt to make more money. In other words, they get more cash coming in than it pays to creditors. And because interest is tax-deductible, success in making more money will ultimately increase shareholder wealth.
And, the solvency ratio is important to show a company’s ability to meet its long-term debt obligations. Along with liquidity ratios, analysts often use them to measure a company’s financial health. Creditors often use it to indicate whether a company has sufficient cash flow to meet its contractual obligations. They analyze a company’s creditworthiness using this ratio before making a decision.
If a company cannot pay its debt bills, it is in an insolvency condition. Creditors may file for bankruptcy in court to force the company to liquidate its assets to pay off debt.
Then, this ratio is important for stock investors to assess how safe the company’s shares are. Higher leverage indicates the riskier the stock is because investors can only claim the company’s assets after the obligations to creditors are fulfilled. In extreme cases, for example, when a company goes bankrupt, all assets may be reserved for creditors and nothing left for shareholders.
How is the liquidity ratio different from the solvency ratio?
The solvency ratio and liquidity ratio are important to measure the company’s financial health. Both measure how capable the company is of meeting its obligations. However, the solvency ratio evaluates the prospects for fulfilling all of the company’s obligations, including long-term debt. Meanwhile, the liquidity ratio looks at obligations that mature in the short term or less than the next twelve months.
Then, the liquidity ratio looks at how capable the company can cover short-term obligations using its most liquid assets such as cash, marketable securities, and receivables. In contrast, the solvency ratio looks at all of a company’s assets to pay off debt, including long-term debt.
How is the solvency ratio calculated?
Calculating the solvency ratio requires looking at income statements and balance sheet data. Because we calculate how well a company can cover its financial obligations, we use the company’s actual cash flow by adding back accounts such as depreciation and non-cash expenses to net income to show how much cash the company can generate to pay principal or interest. In addition, we also see how much the company’s debt is in its assets. In general, the calculations are relatively simple because they require arithmetic operations.
What are examples of solvency ratios?
We can use several metrics to measure the solvency of a company. The debt-to-equity (D/E) ratio is one of them, where it shows us the relative proportion of debt to equity. Other frequently used metrics are:
- Debt-to-assets ratio
- Debt-to-capital ratio
- Debt-to-equity ratio
- Interest coverage ratio
- Fixed-charge coverage ratio
As the name suggests, we calculate the debt to assets ratio by dividing total debt by total assets. We can find these two numbers on the balance sheet. Meanwhile, the total debt I mean here is the total interest-bearing debt, both short-term and long-term.
So, this ratio shows us how much the company uses debt to finance assets. Here is the mathematical formula:
- Debt‐to‐assets ratio = Total debt / Total assets
A higher debt-to-asset ratio is undesirable. That implies higher financial risk as the company depends more on debt to grow its assets. In other words, we say the firm’s solvency position is weaker and may have difficulty meeting its debts.
The debt-to-capital ratio shows the proportion of debt in the company’s capital structure. Debt has the consequence of regular outflows (interest payments), whereas equity does not.
- Debt‐to‐capital ratio = Total debt / Total capital
- Debt‐to‐capital ratio = Total debt / (Total debt + Total equity)
A higher debt-to-capital ratio indicates a higher financial risk because the company relies more on debt than equity. And, because of that, it’s less than desirable. So, if the debt is too high, why don’t companies prefer equity over debt?
The company uses its debt capital structure because it is cheaper. The cost of debt is tax-deductible. But, too much debt is also not good because the company has to pay interest regularly.
So, debt is a good alternative if the additional money generated is more than the extra cost of capital borne. For this reason, companies must look for an optimal composition of equity and debt capital.
Debt‐to‐equity ratio (DER)
The debt-to-equity ratio (DER) measures a company’s relative proportion of debt capital to equity capital. First, we add up short-term debt and long-term debt to calculate it. Then, we divide it by the total equity. The following is the DER formula:
- DER = Total debt / Total equity
- DER = (Short-term debt + Long-term debt) / Total equity
The DER will be high if the company relies too much on debt rather than equity. Conversely, if it is less, it will be lower. And, companies with lower DER is less risky than those with higher ratios.
Interest coverage ratio
The interest coverage ratio measures how well the company is able to pay interest. To measure it, we compare the company’s ability to generate cash with the interest expense paid.
EBIT is a commonly used metric as the numerator. It is a measure to indicate how much cash the company generates.
We probably won’t find them on the income statement, and because of that, we calculate them manually. For example, suppose we start with net income. In that case, we calculate EBIT by adding back tax expense and net interest expense to net income. Alternatively, we can start from the top line of the income statement (i.e., revenue) and use the following formula:
- EBIT = Revenue – Cost of goods sold – Selling, general and administrative expenses + Interest income + Other income (expenses)
Then, to calculate the interest coverage ratio, we divide EBIT by interest expense. If it is higher, it indicates the company can better pay interest because it makes more money than it pays out as interest. Conversely, if it is close to or less than 1 signals serious difficulties in paying interest.
- Interest coverage ratio = EBIT / Interest expense
Furthermore, as the numerator, we can also use an alternative other than EBIT, namely EBITDA. It is more reflective of the actual cash generated by the company than EBIT because it is adjusted for non-cash items, namely depreciation and amortization expenses. Other commonly used metrics are Free Funds from Operation (FFO) and Cash Flow from Operations (CFO), as in corporate credit analysis.
Unlike the interest coverage ratio, fixed charge coverage accommodates routine financial expenses other than interest expense, namely lease payments. We first add the rent expense to EBIT and use the result as the numerator to calculate the ratio. Then, as the denominator, we add the interest expense to the rent expense. The mathematical formula is as follows:
- Fixed-charge coverage = (EBIT + Rent expense) / (Interest expense + Rent expense)
The fixed-charge coverage ratio evaluates a company’s ability to meet its fixed financial costs: interest payments and lease payments. As with interest expense, the company must pay rent, regardless of whether the company makes money or not.
A lower high ratio is preferable because it indicates the company is making enough money from operating activities to pay interest and rent.
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