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Solvency Ratio
A performance metric that helps us examine a company’s financial
health

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Written by CFI Team

What is a Solvency Ratio?

A solvency ratio is a performance metric that helps us examine a
company’s financial health. In particular, it enables us to determine
whether the company can meet its financial obligations in the long term.

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key skills in commercial lending,
The metric is verycredit,
useful to lenders, potential investors, suppliers, and
capital markets,
any otherandentity
more!that would like to do business with a particular

company. It usually compares the entity’s profitability with its obligations

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to determine whether it is financially sound. In that regard, a higher or
strong solvency ratio is preferred, as it is an indicator of financial
 strength. On the other hand, a low ratio exposes potential financial
hurdles in the future.

Summary

The solvency ratio helps us assess a company’s ability to meet

its long-term financial obligations.

To calculate the ratio, divide a company’s after-tax net income

– and add back depreciation– by the sum of its liabilities
(short-term and long-term).

A high solvency ratio shows that a company can remain

financially stable in the long term.

How to Calculate the Solvency Ratio

As explained later, there are a couple of other ways to determine a

company’s solvency, but the main formula for calculating the solvency
ratio is as follows:

Solvency Ratio = (Net Income + Depreciation) / All Liabilities (Short-term

+ Long-term Liabilities)

If you examine keenly, you will notice that the numerator comprises the
entity’s current cash flow, while the denominator is made up of its
liabilities. Thus, it is safe to conclude that the solvency ratio determines
whether a company’s cash flow is adequate to pay its total liabilities.

Practical Example

Let’s look at the case of SaleSmarts Co.:

SaleSmarts (USD in millions)

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Net Income 45,000
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Depreciation 15,000
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Short-term Liabilities 83,000

Long-term Liabilities 160,000

Solvency Ratio = (45,000 + 15,000) / (83,000 + 160,000)

 Solvency Ratio = 0.246 * 100 = 24.6%

Important to note is that a company is considered financially strong if it

achieves a solvency ratio exceeding 20%. So, from our example above, it
is clear that if SalesSmarts keeps up with the trend each year, it can
repay all its debts within four years (100% / 24.6% = Approximately four
years).

Limitation of the Solvency Ratio

Although the solvency ratio is a useful measure, there is one area where
it falls short. It does not factor in a company’s ability to acquire new
funding sources in the long term, such as funds from stock or bonds. For
such a reason, it should be used alongside other types of analysis to
provide a comprehensive overview of a business’ solvency.

Other Solvency Ratios

Financial ratios enable us to draw meaningful comparisons regarding an

organization’s long-term debt as it relates to its equity and assets. The
use of ratios allows interested parties to assess the stability of the
company’s capital structure. Here are a few more ratios used to evaluate
an organization’s capability to repay debts in the future.

1. Debt-to-Equity (D/E) Ratio

Often abbreviated as D/E, the debt-to-equity ratio establishes a

company’s total debts relative to its equity. To calculate the ratio, first,
get the sum of its debts. Divide the outcome by the company’s total
equity. This is used to measure the degree to which a company is using
debt to fund operations (leverage).

2. Interest Coverage Ratio

With the interest coverage ratio, we can determine the number of times
that a company’s profits can be used to pay interest charges on its debts.
To calculate the figure, divide the company’s profits (before subtracting
any interests and taxes) by its interest payments.
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The higher the value, the more solvent the company. In other words, it
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means the day-to-day operations are yielding enough profit to meet its
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interest payments.
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3. Debt-to-Capital Ratio

As implied in the name, the debt-to-capital ratio determines the

proportion of a business’ total capital that is financed using debt. For
 example, if a company’s debt-to-capital ratio is 0.45, it means 45% of its
capital comes from debt. In such a case, a lower ratio is preferred, as it
implies that the company can pay for capital without relying so much on
debt.

Wrap Up

Before an individual or organization invests or lends money to a

company, they need to be sure that the entity in question can remain
solvent over time. Thus, interested stakeholders utilize solvency ratios to
assess a company’s capacity to pay off its debts in the long term.

A high solvency ratio is an indication of stability, while a low ratio signals

financial weakness. To get a clear picture of the company’s liquidity and
solvency, potential investors use the metric alongside others, such as the
debt-to-equity ratio, the debt-to-capital ratio, and more.

More Resources

Thank you for reading CFI’s guide to Solvency Ratio. To keep advancing
your career, the additional CFI resources below will be useful:

Common Size Ratio

Financial Ratios

Insolvency

Shareholder Equity Ratio

See all commercial lending resources

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