# Solvency Ratio

A solvency ratio provides a thorough assessment of a company's ability to remain financially stable by focusing on actual cash flow, which includes non-cash expenses like depreciation.
Solvency Ratio
3 min
23-July-2024
A solvency ratio is a financial metric indicating a company's overall financial health. It determines the ability of a company to cover its long-term liabilities. This ratio specifically measures how well a business generates cash flow to meet its future debt obligations.

This ratio is particularly valuable for investors and shareholders who want to assess the company's profitability and financial strength. Let’s understand the solvency ratio meaning and interpretation in detail, learn how to calculate it, and understand its various types.

## What is the solvency ratio?

The solvency ratio is a widely used tool to check whether a company can meet its long-term debt obligations and remain financially stable. It shows if the company makes enough money to cover what it owes in the future. This ratio is particularly important for:

Investors

Creditors

Shareholders

Financial analysts

Using the solvency ratio, they evaluate a company's risk of default and its capacity to sustain operations over the long term. Some common solvency ratios are:

Debt-to-equity ratio

Interest coverage ratio

Proprietary ratio

Debt ratio

It is worth mentioning that while calculating solvency, the first factor considered is cash flow. This means companies check how much money is coming in and going out, considering all expenses and depreciation (the decrease in the value of assets over time). This cash flow analysis helps in gauging their financial strength.

Additionally, when assessing solvency, companies consider all their debts and not only their short-term debt obligations. This gives a comprehensive view of the company's financial commitments.

## Formula for solvency ratio

The solvency ratio shows how well a company can cover its debts with the:

Profit earned by the company (net profit)

and

The value of its assets (after charging depreciation).

To calculate the solvency ratio, we can use the following formula:

 Solvency ratio = (Net profit after tax + Depreciation)/(Short-term liability + Long-term liability)

Let’s understand each of these terms:

Net profit after tax

This is the actual profit earned by the company after paying all its expenses and taxes.

Depreciation

This represents the decrease in value of the company's assets over time, like machinery or buildings.

Even though it's not money spent, it's considered because it affects the overall financial picture.

Short-term liability

These are debts or obligations the company needs to pay off within a year, like short-term loans or bills payables.

Long-term liability

These are debts or obligations the company needs to pay off over a longer period, usually more than 12 months. Some common examples are long-term loans, leases payable, etc.

## How to calculate the solvency ratio?

The first step in calculating the solvency ratio is determining the company’s net profit after tax. For the unaware, it represents the total earnings after all expenses and taxes have been subtracted from revenue. You can take this information from the company’s income statement.

Next, you need to identify depreciation. For the unaware, depreciation is an accounting entry. It reflects the decrease in value of a company's assets as they age or are used in operations. Also, it is considered a non-cash expense because it doesn't involve actual cash outflows but affects the overall financial picture by reducing the asset's recorded value over its useful life. You can find depreciation on the income statement or cash flow statement.

Lastly, determine the total liabilities of a company, including both:

Short-term liabilities (debts or obligations due within one year)

and

Long-term liabilities (debts or obligations due beyond one year)

You can take these figures from the company’s balance sheet. Now, you need to simply apply the solvency ratio formula:

 Solvency ratio = (Net profit after tax + Depreciation)/(Short-term liability + Long-term liability)

## Example of calculation of solvency ratio

Let’s learn the calculation of the solvency ratio better through a hypothetical example involving a company called "ABC Manufacturing Ltd." Consider the following data extracted from its income statement and balance sheet:

Net profit after tax: Rs. 20,00,000

Depreciation: Rs. 5,00,000

Short-term Liabilities: Rs. 10,00,000

Long-term Liabilities: Rs. 40,00,000

Now, we will apply the solvency ratio formula:

 Solvency ratio = (Net profit after tax + Depreciation)/(Short-term liability + Long-term liability)

Solvency ratio = (20,00,000 + 5,00,000)/(10,00,000 + 40,00,000)

Solvency ratio = 25,00,000/(50,00,000 )

Solvency ratio = 0.5

Interpretation

A solvency ratio of 0.5 means that ABC Manufacturing Ltd. has Rs. 0.50 in net profit and depreciation for every rupee of total liabilities.

This indicates that the company has moderate financial health.

ABC Ltd. has a reasonable ability to cover its long-term debt obligations.

Generally, a higher solvency ratio is preferable as it suggests a stronger financial position.

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## Types of solvency ratios

To better assess a company's ability to meet its long-term debt obligations, we can divide the solvency ratios into various types, with some common ones being:

Debt-to-equity ratio

Debt ratio

Proprietary ratio or Equity ratio

Interest coverage ratio

Let’s understand each of them in detail:

### 1. Debt-to-equity ratio

The debt-to-equity ratio measures how financially leveraged a company is by comparing its total debt to its shareholders' equity. This ratio shows how much debt is being used to finance the company's assets relative to the value of shareholders' equity. The formula is:

 Debt-to-equity ratio =(Long-term debt)/(Shareholder's equity)

A higher ratio means more debt relative to equity, which indicates higher financial risk. Conversely, a lower ratio suggests a more conservative approach to leveraging.

### 2. Debt ratio

The debt ratio also assesses a company's financial leverage. However, it does so by comparing its total liabilities to its total assets. This ratio shows the proportion of a company's assets that are financed by debt. The formula is:

 Debt ratio = (Total assets)/(Total liabilities)

A higher debt ratio indicates more risk. That’s because it implies a larger portion of the company’s assets are financed through debt. On the other hand, a lower ratio is generally preferable as it shows a company is less reliant on debt for asset financing.

### 3. Proprietary ratio or Equity ratio

The proprietary ratio (also known as the equity ratio) measures the proportion of shareholders' equity to total assets. This ratio shows the extent to which shareholders' funds cover the company’s assets. The formula is:

 Proprietary ratio = (Shareholders' equity)/(Total assets)

A higher equity ratio indicates a strong financial position with more assets financed by shareholders rather than debt. This is considered favourable for the company's:

Long-term solvency

and

Financial stability

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### 4. Interest coverage ratio

The interest coverage ratio shows how easily a company can pay interest on its outstanding debt. It is calculated using the following formula:

 Interest coverage ratio = (Earnings before interest and taxes (EBIT))/(Interest expense)

A higher ratio shows that the company is more capable of meeting its interest obligations and has robust financial health. On the other hand, a lower ratio suggests potential difficulties in covering interest payments with chances of default.

## Is a high solvency ratio good?

Yes, generally, a high solvency ratio is considered favourable. That’s because it indicates that a company has a strong ability to meet its long-term debt obligations using its available resources.

This fact is usually reassuring to investors and creditors as it suggests that the company is:

Financially stable

and

Less likely to default on its debt payments

Also, a high solvency ratio indicates that the company has effective financial management practices in place. For example:

Prudent debt management

Availability of sufficient cash flow to cover its obligations over the long term

However, it's important to note that the ideal level of solvency varies across industries and depends on factors such as:

Economic conditions

Growth strategy

Moreover, extremely high solvency ratio is also not preferred. That’s because it shows that the company is not leveraging debt effectively to finance growth opportunities, which is limiting its profitability.

## Is solvency the same as debt?

It is worth noting that solvency and debt are related concepts, but they are not the same. Solvency refers to the ability of a company to meet its long-term financial obligations, including debt payments. It is a broader measure of financial health that considers whether a company has enough resources (assets) to cover its long-term liabilities (debts) as they become due.

Debt, on the other hand, specifically refers to the amount of money that a company owes to external parties, such as:

Banks

Bondholders

Other creditors

It represents the financial obligations that must be repaid over time.

Hence, solvency shows whether a company can meet all of its long-term obligations. On the other hand, debt focuses on the:

Specific amounts owed

and

The terms under which they must be repaid

## Limitation of the solvency ratio

Despite being a valuable tool to assess a company’s financial health, the solvency ratio has certain limitations that are important to consider. Firstly, it doesn't consider the company's potential to raise additional funds through issuing stocks or bonds in the future. Numerous studies have shown that these sources of alternative funding significantly impact a company's ability to:

Manage its debt

and

Maintain solvency over the long term

Thus, to overcome this limitation, investors must use solvency ratio analysis with other types of financial analysis, such as:

Examining a company's cash flow projections

How historically successful has the company been in raising capital?

Can the company access credit markets easily?

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## Differences between solvency ratio and liquidity ratio

As discussed above, solvency ratios check whether a company can meet its long-term debt obligations using its assets. On the other hand, liquidity ratios evaluate a company's ability to pay immediate or short-term obligations with available assets.

Hence, we can observe that both ratios offer distinct perspectives on:

Financial health

and

Risk management

Let’s learn some key differences between them:

 Parameters Solvency ratio Liquidity ratio What does it mean? Measures a company's ability to meet long-term debt obligations. Measures a company's ability to pay off short-term liabilities with current assets. Which type of liability does it cover? Long-term liabilities Short-term liabilities What does it indicate? Indicates long-term financial stability and profitability Indicates how easily assets can be converted to cash. What are some popular ratios? Debt to equity ratioInterest coverage ratioProprietary ratio Current ratioQuick ratioAcid test ratio How risky is it? High risk as insolvency can lead to bankruptcy. Low risk, but affects creditworthiness. What balance sheet items does it focus on? DebtShareholders’ equityLong-term assets Current assetsCurrent liabilities

## Conclusion

The solvency ratio is a popular financial metric that determines whether a company can meet its long-term liabilities using the available resources. It specifically focuses on long-term liabilities and overall financial stability.

Some common solvency ratios are debt-to-equity ratio, proprietary ratio, and interest coverage ratio. Usually, a high solvency ratio is considered favourable as it shows that the company has good financial health and has a low risk of default.

The solvency ratio is different from the liquidity ratio, which measures a company's ability to pay short-term liabilities with current assets. While the solvency ratio focuses on the long-term obligations of a company, the liquidity ratio focuses on immediate financial obligations and cash flow. Some common liquidity ratios are the current ratio and quick ratio.

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What is the solvency ratio?
The solvency ratio determines whether a company can meet its long-term debt obligations using its assets.

What is the highest solvency ratio?
As per IRDAI regulations, insurance companies are required to maintain a minimum solvency ratio of 1.5 or a solvency margin of 150%. This high solvency ratio acts as a financial buffer and ensures that the insurance companies can meet all obligations even during severe financial stress or high claim periods.

Is a solvency ratio of 1 good?
A solvency ratio of 1 indicates that a company's assets are equal to its liabilities. This is generally considered good as it shows optimal financial balance.

What is a 30% solvency ratio?
A solvency ratio of 30% means that for every unit of liability, the company has 30% in assets. This is a good solvency ratio and shows moderate financial health.

How is the solvency ratio calculated?
The solvency ratio is calculated by dividing the sum of net profit and depreciation by total liabilities for the accounting period.

What are the 4 solvency ratios?
The solvency ratios are the debt-to-equity ratio, interest coverage ratio, proprietary ratio, and debt ratio.

What is the minimum solvency ratio?
The minimum solvency ratio varies by industry. However, generally, it should be above 1 to indicate financial stability.

What is another name for a solvency ratio?
Solvency ratios are also known as leverage ratios. That’s because they measure a company's ability to meet its long-term financial obligations.

How to improve the solvency ratio?
To improve its solvency ratio, a company should focus on paying off debts and improving profitability. This reduces financial risk and gradually develops stronger financial health.

What are the advantages of solvency ratios?
Solvency ratios assess a company's ability to manage debt. They analyse financial stability and imply whether the company can meet its long-term liabilities without any default.

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