Solvency Ratios – Definitions, Types, Formulas
Solvency ratios are essential indicators of a company’s long-term financial stability. Investors, creditors, and bankers use them to evaluate businesses’ ability to cover their long-term obligations.
There are two groups of solvency ratios: capital structure and coverage ratios. Discover their definitions, usages, common types, and applications.
What Are Solvency Ratios?
A firm’s ability to meet its long-term financial obligations is called solvency. Analysts, investors, and prospective lenders use solvency ratios to evaluate a firm’s long-term financial health and creditworthiness.
A solvent business owns more than it owes in the long term and has a manageable debt load. A high solvency ratio indicates a firm’s ability to stay afloat or become debt-free. At the same time, a low one signals the company will struggle to repay its long-term obligations and may go bankrupt.
Liquidity vs Solvency
Both liquidity and solvency ratios measure companies’ ability to cover their debt, but the former focuses on the short term and the latter on the mid- and long-term.
Liquidity ratios help determine whether a company has enough cash to pay its short-term obligations. But this does not guarantee long-term survival. An organization may be exquisitely capable of managing its cash in- and out-flows and still become vulnerable because of its excessive debt load.
That’s why financial analysts also consider a firm’s solvency—i.e., its ability to meet non-current obligations and survive in the long run.
So, what do solvency ratios measure? Let’s review all types to find out.
Types of Solvency Ratios
There are two fundamental questions one should answer to assess whether a firm can service its long-term debt:
- Does it have enough assets to cover its obligations?
- Does it generate enough money to pay its dues and become self-sufficient and debt-free?
Based on this, we differentiate between two groups of solvency ratios: capital structure and coverage ratios.
Capital Structure Ratios
There are two ways to finance a company: debt and equity. Many organizations use a combination of both. Capital structure ratios examine this mixture and how it changes over time. The most widely used metrics from this group include the following:
- Financial leverage
We calculate these solvency ratios using values from the firm’s Balance Sheet.
As the name suggests, the D/E ratio measures the proportion of a company’s debt to its equity. It reveals how a company is funded and how much of its long- and short-term debt can be covered by its equity if needed. Note that this excludes short-term operational obligations, such as trade payables or unearned revenue.
The higher the D/E ratio, the bigger the likelihood of default and the riskier the investment in this company. Still, having zero debt does not guarantee perfect financial health. On the contrary, debt is a valuable financial tool that managers should utilize to expand the business.
The cost of debt is tax-deductible and arguably lower than the cost of equity. Taking on debt to increase the firm’s asset base should increase the return on existing equity. So, companies should strive for a healthy mix of debt and equity. And debt-to-equity solvency ratios indicate whether they’ve achieved this balance.
The debt-to-capital ratio estimates a firm’s total debt in relation to its total capital, including debt and equity and excluding operational and tax liabilities. The metric reveals what share of the firm’s financing comes from debt.
The higher the D/C ratio, the larger the share of debt compared to equity financing. This metric excludes the operational part of the firm’s indebtedness and only deals with the structure of external financing.
These solvency ratios may conceal risk by omitting potentially large accounts, such as accounts payable. Still, some analysts prefer them to debt-to-equity ratios since they provide a broader overview of the firm’s financing structure.
The debt-to-assets ratio examines a firm’s total debt compared to its total assets. In other words, it reveals what portion of the company’s debts can be paid off with its assets. In this case, debt includes all liabilities, from bank credits to trade payables, deferred taxes, unearned revenue, wages payable, etc.
А higher ratio indicates that the company is indebted and lacks sufficient assets to cover its obligations.
The last multiple we’ll examine from this group of solvency ratios is financial leverage. This ratio looks at a firm’s equity compared to its total assets and indicates how much of the asset amount belongs to the shareholders vs creditors.
The higher the company’s financial leverage ratio, the higher the returns to equity owners and debt levels. So, leverage is only good up to a point—servicing excessive debt decreases the company’s cash flows and earnings, thus limiting its ability to reinvest in its future growth.
Coverage ratios consider a firm’s income relative to its debt as an indicator of the ability to service its obligations. We calculate them using values from the company’s Income Statement and Balance Sheet. The three most popular coverage metrics include:
- Solvency ratio
- Interest coverage ratio
- Fixed-charge coverage ratio
The solvency ratio assesses whether a company generates enough cash flow to service its short- and long-term debt.
The higher the ratio, the lower the probability of defaulting on its obligations. As a rule of thumb, anything above 20% is considered good, although this varies across industries.
Interest coverage [or times-interest-earned (TIE) ratio] examines a firm’s ability to pay the interest on its debt. It reveals how often the firm’s operating profit can cover its interest expense.
*EBIT = Earnings before interest and taxes
The higher the ratio, the more latitude the firm has to cover its interest payments. Generally, an interest coverage ratio below 1.5 is considered low, but this varies across industries.
Fixed-charge coverage measures a firm’s ability to pay its fixed obligations, such as a debt’s principal and interest payments, rent, and utilities. In other words, it tells us how often a company’s operating profit can cover its fixed expenses.
This type of solvency ratio is a more conservative iteration of interest coverage because it adds more expenses to EBIT. It omits fixed debt payments and preferred dividends not appearing on the Income Statement. To have a fair assessment of the company’s ability to service its fixed charges using its operating profit, we should add them to EBIT in the numerator.
Alternatively, we can take the firm’s revenue and subtract all non-fixed charges in the numerator.
The higher the fixed-charge coverage ratio, the more capable a firm can meet fixed costs in times of falling revenue. This ratio recognizes that directly related costs will also decrease when sales drop. Still, companies have fixed costs to cover regardless of their sales volume. So, this analysis is particularly suitable for firms with significant lease obligations, insurance, debt installments, and other fixed obligations.
The Bottom Line
Solvency ratios concern a company’s ability to service its debt in the long term. They are a valuable tool for investors and financial analysts to evaluate financial health and stability. Still, to conduct a comprehensive ratio analysis, one needs to understand and use various types of financial ratios in conjunction.
Our comprehensive Financial Ratio Analysis course teaches you how to do this. Sign up for 365 Financial Analyst to access our entire course library and take your financial analysis skills to the next level.
And if you’d like to know how to calculate these ratios in Excel, take a look at our solvency ratios template.