How to Calculate Solvency Ratio?

Key Highlights

• Solvency ratios analyse a company's long-term debt and interest paid on it.

• A business with high liquidity can handle unforeseen financial crises. However, it cannot guarantee that it will be able to repay its entire debt over time.

• A higher solvency ratio indicates financial stability. On the other hand, lower solvency ratio shows financial weakness.

• Investors should regularly monitor the solvency ratio to determine the financial health of a firm.

What is a Solvency Ratio?

The solvency ratio measures a company's ability to pay off long-term debts and maintain financial stability. As part of their daily operations, businesses must deal with various financial commitments. Some of these include short-term obligations, like salaries of employees.

Businesses can easily cover short-term obligations with existing assets and regular cash flow. Conversely, it may be more challenging to pay off long-term debt. The capacity of a company to meet these long-term commitments is the main focus of a solvency ratio.

Calculating Solvency Ratio

You require two essential components for understanding how to calculate solvency ratio. The first is the company's net earnings before depreciation, while the second is total liabilities. The company's income after subtracting expenditures, taxes, interest, depreciation, amortisation, and cost of products sold is known as ‘net earning’. By adding depreciation to net income, you can calculate net earnings before depreciation.

Long-term and short-term liabilities are a firm's total liabilities. Accumulated costs, payable expenses, short-term debt, and some examples of short-term obligations. All other debt like bonds, debentures, and bank loans with a long duration, are long-term liabilities.

The financial statements of a company provide all the data required to calculate the solvency ratio. Here is the formula for solvency ratio.

Solvency Ratio = (Net income + Depreciation) / Total Liabilities

Example of Solvency Ratios

For more clarity, let's use an example to understand the calculation.

Two businesses, X and B, are involved in the same industry of toy manufacturing. Saket is looking to invest in one of these companies. He found that both businesses were operating well in terms of profitability and liquidity parameters. So, he thought of comparing the solvency of the two businesses.

At the end of the year, the company provided the details from their balance sheet. Based on this, let's examine the solvency of the two firms.

The calculation for Company X is as follows:

Depreciation = 7% of Rs. 8,00,000 = Rs. 70,000

Solvency Ratio = (Net income + Depreciation) / (Short-term debt + Long term debt)
= (Rs. 3,00,000 + Rs. 70,000) / (Rs. 3,50,000 + Rs. 4,00,000)
= 0.49 or 0.49%

The calculation for Company Y is as follows:

Depreciation = 5% of Rs. 8,00,000 = Rs. 40,000

Solvency Ratio = (Net income + Depreciation) / (Short-term debt + Long term debt)
= (Rs. 3,50,000 + Rs. 40,000) / (Rs. 2,00,000 + Rs. 3,50,000)
= 0.7 or 0.7%

So, based on the solvency ratio, Saket should invest in Company X. This is because Company X has a higher solvency ratio than Company Y. So, for every rupee of liability, it generates net income of Rs. 0.7. Company X has less chances of defaulting on repayments than Company Y.

Other Solvency Ratios

There are different types of solvency ratios. The following are some important ones.

Debt to Equity Ratio Formula (D/E)

The debt-to-equity ratio (D/E) indicates the proportion of funding provided by creditors relative to equity investors. It is calculated by comparing a company's total debt balance to its total shareholders' equity account.

Formula:

Debt to Equity = Total Debt / Total Shareholder's Equity

• When a company's debt-to-equity ratio (D/E ratio) is 1.0x, it indicates that creditors and investors own an equal portion of the company's assets.

• A lower D/E ratio suggests that the business is less vulnerable to solvency risk. It is more financially secure.

Debt to Assets Ratio (D/A)

The debt-to-assets ratio assesses how much debt a business has overall compared to the total value of its assets. It is the value of assets remaining after all the firm's creditors are paid off. The ratio assesses whether the company has enough assets to pay all its commitments, both short- and long-term.

Formula:

Debt to Assets = (Short Term Debt + Long Term Debt) / Total Assets

• A lower debt-to-assets ratio indicates that the business has enough assets to pay off its debt. Hence, the company's financial situation is steady.

• When firms have a 1.0x debt-to-assets ratio, it indicates that the assets and debt are equal. Therefore, to settle its financial obligations, a company must sell off all its assets.

• Higher debt-to-asset ratios suggest that the business cannot continue to carry its existing level of debt.

Debt to Capitalisation Ratio (D/A)

This ratio calculates the total outstanding debt as a percentage of the total capitalisation of the company.

Formula:

Debt to Capitalisation = Total Debt / (Total Debt + Total Equity)

Interest coverage ratio

The interest coverage ratio shows the ability of a firm to pay interests on its debt. By dividing the company's earnings before interest and taxes by the interest paid, you can get the interest coverage ratio.

Formula:

Interest Coverage Ratio = Interest Expense/EBIT

where; EBIT = Earnings before interest and taxes.

Conclusion

An investor must be certain that a firm can remain financially stable before making an investment. Moreover, lenders need to know this before providing or extending a loan. So, investors and lenders can use solvency ratios to evaluate a company's long-term ability to fulfil its obligations. While a low ratio denotes financial weakness, a high ratio is a sign of stability. Potential investors use solvency ratios, along with this other metric, to obtain a comprehensive view of the company's liquidity and solvency. You can use a solvency ratio calculator on an excel sheet to easily analyse different companies.